Thursday, February 19, 2015

A UK Portfolio 2014 - 2016


This is the third in a series [2012 to 2014 is here and 2013 to 2015 is here].

The UK market is now an uncomfortable place to be and what follows will I suspect be of interest only to a few.



I have said my piece about about Lombard Risk and Lamprell and I don't have anything new to add. I am allocating 20% to cash. The opportunities and risks attached to Dolphin Capital and Goodwin are as you see them so I'll only sketch Hogg Robinson, Hargreaves Services, Findel, and Cambria.

Hogg Robinson

I own shares in Hogg Robinson, a travel management company catering to multinational organizations with large traveling populations (Volkswagen, for example), confederations with special travel needs (the NBA, Cricket Australia), as well as governments and inter-governmental bodies (UK, Canada; NATO).

Its financial statements look fairly placid but belie both the structural transformations playing out in the managed travel industry and the neurosis that periodically grips the market about HRG's ability to align its strategy and cost structure accordingly. (There is, of course, a whole subculture dedicated to forecasting what "Managed Travel 2.0" will look like. I recommend the white papers at the website of Carlson Wagonlit).


We get a better view of what's going on if we adjust for a few items.

First, it appears that HRG lost 8 million in revenue in H1 2015 due to the strength of sterling and, second, it lost 6 million as a result of reduced European travel for cyclical reasons.

I think it reasonable to add those back to get normalized figures and to account for cyclicality instead via the modesty of the 10x multiple applied to the resulting FCF (10x unlevered FCF is equivalent to 8x EBIT). 

The company has also begun the process of rationalizing its cost base -- it has incurred the special charges but the annualized benefits have obviously not yet shown up. I add those back too.



There has been a rise and an acceleration in self booking of travel tickets among the traveling populations in its client roster. Each 5% increase in self-booking appears to reduce revenue by 1 million. The share of tickets that are self-booked will continue to increase and might hit a wall at ~80%. That would reduce run rate revenue by 25 million. It is low quality revenue since the margins are necessarily thin -- but no matter.

HRG has indicated that it will cut another 20 million out of its cost structure by rationalizing offices and reducing headcount. I add that back in the 2018 figures.



So we are left with a slightly smaller but more profitable revenue base and a forward FCF yield that cannot be sustained.


SpendVision would, in other hands, be more valuable than HRG itself. It is a wild exaggeration to say that it is a mini Concur but there are similarities in its potential. The combined value of SpendVision's potential and Travel Management's cash generative properties would, I think, make this HRG attractive to private equity. It has, in fact, been taken private in the past. 

Things to pay special attention to:


Think about who you'd target if you ran a travel management company with six thousand staff and a presence in 120 countries.

First on your list, surely, would be large multinational corporations with complex travel needs -- that is, with employees who frequently travel to and from places with higher than average security risk; higher than average flight cancellation risk; and higher than average need for local knowledge about where to stay, how to get around in country, and what to do in case this or that happens. The oil majors and the ecosystem that supports them maybe would be the place to start.

This is what it says in the H1 2015 report:


    "Our focus of targeting the provision of specialised travel services to companies operating in the marine, offshore and energy sectors is paying off.  HRG's track record over many years of successfully managing complex travel has resulted in new business wins during the period with Baker Hughes, Orica and Subsea 7, adding to a roster that includes, amongst others, ConocoPhillips, DOF Marine, Statoil and Tullow Oil."

It is awfully perplexing that this should be a new idea in 2015. At the same time, one does feel mollified that there is something that approximates a strategy in the works.

Second, the pension deficit is more substantial than the company's market capitalization. If corporate bond yield fall further, the deficit will widen. If corporate bond yields rise by 2% or so, the deficit will disappear. That would add 60p in value to the shares and therefore renders them an okay way to hedge against the possibility of a rising interest rate environment.

Hargreaves Services

HSP is a mix of good and bad businesses. The bad businesses -- surface mining of coal in the UK and bulk trading of thermal coal throughout Europe -- are not always bad and in any case enable HSP to profit from the trading of specialty coals.

Pulling together the contents of HSP's latest filing lets us draw this picture:


and therefore



and finally


Findel

The thing to do with Findel is, I think, to temporarily set aside everything but the Express Gifts segment. Its closest publicly traded comparable is  N Brown.



The other segments may not, in the end net out to zero. Kitbag is under "strategic review" and has received multiple expressions of interest. The education business is probably more cyclical than structurally challenged. Nevertheless, if Findel's share price rises -- and stays -- above 479p 8.34 million convertible shares come into play and negate the benefits of an improvement in these businesses.

Something to pay attention to: Management has an economic interest reporting ever improving EPS figures. This can be good and it can also be bad. It can, in a business quite reliant on securitized receivables and in one targeted at (or is it targeted to? or, perhaps, "serving") the working poor, become quite tempting to engage in risky operating and accounting practices.

Cambria Automobiles

The business model of a car dealership is to sell cars in order earn a profit on the sale of aftersales products and services. It can be done well and it can be done badly. The people who run Cambria do it well. They buy underperforming dealerships and make them profitable. 2.5% to 3% EBIT margin  represents very good performance in the dealership business. Cambria's margins, at 2% on average, reflect a mix of dealerships under its buy and improve strategy. 

As is, Cambria could (should) be valued as follows: 



so that



although, of course, the latest IMS suggests that the performance of the very latest acquisitions is such that there will be a substantial advance in the group's revenue base so there may be upside beyond what I've suggested here.

If the pace of acquisitions slows and we see 2.5% margins the shares would be worth 130p. That is also what it would be worth to a private buyer.

---

Of course this exercise is fun only if y'all dig in for yourselves, use your own judgment, and push back where appropriate so I look forward to that. 

Disclosure: I own shares in Hogg Robinson

37 comments:

  1. HSP has been a disaster recently, but good to see it in the portfolio...

    Agree with general theme of thesis, but with a caveat: aren't you mixing the UK Coal & Europe Speciality coal together? Europe Speciality was much less profitable (50% less) than UK, but it appears that Europe (primarily German coking coal) has completely imploded and is essentially shut down...pre-tax profits were zero in the first half if I'm reading correctly? Also, the UK Speciality Coal is seeing margin pressure.

    So wouldn't the low case be something like:

    Germany = 0 EBIT
    UK = 680 tons (flat volume) x 15/ton (margin pressure) = 10.2m

    Normalized is prob higher, but using 10m as low case really hurts the downside valuation of the business, no?

    Also, curious what you think liquidation value would be in run-off scenario? Balance sheet is liquid, with BV at 150m (lots of readily marketable coal + WC turning to cash) with another half year of high profits before things collapse. Isn't downside capped at book value + 2H profits on + CF from simplification program? And won't BV only grow from there with future profits, even if lower than anticipated?

    Find it hard to see how BV can be impaired significantly unless Production losses overwhelm other divisions, but can you see a further disaster scenario? Thoughts?

    Would be great to get your thoughts on these two points, and if you have a stab at liquidation value/calculations.

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  2. Hi red,

    great stuff to read, thank you. I've got just one question that I hoped to have cleared. So is it correct that you have £13m EBIT for SpendVision for 2018, or a little error? Would be curious to hear how you got there with the current EBIT running at about £3m, unless it was a slip. Anyway, a great writeup once again. There's quite a few assumptions that need to materialize (cyclical revs, currency movements) but if they do, then even with the pension liability simply staying as it is should result in a nice run.

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  3. Barry,

    Sorry -- I'm not sure I follow. This is what I have for 2013 & 2014

    https://www.dropbox.com/s/msxazshp9v55sdr/HSP%204.png?dl=0

    I haven't managed to find any basis for taking Specialty EBIT down to 10. Doesn't mean that the justification isn't there, of course, but I'd appreciate you pointing it out to me if I've missed it.

    Re: liquidation. That's a viable scenario only in the event that (1) Production losses overwhelm specialty profits and (2) the expectation is that production losses will overwhelm Specialty profits in the long term

    That seems to me to be an unlikely scenario but, if it should come about, then Production and bulk trading will shut down and perhaps 70% of net working capital will be released, will offset the remediation costs involved in shutting down the mines.

    At that point, we're left with the specialty trading, industrial, and transport business.

    If an 8x multiple is fair then those businesses would need to generate 19 million in EBIT between them for the current share price to be covered.

    Specialty would have to import its coal from third parties and its margins would therefore be reduced.

    If 15m is resulting run rate Specialty EBIT and the other surviving operations generate 12 million between them, then the company is selling at an implied P/E of 6 which is probably a little too low.

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  4. 60 N,

    I got caught in two minds about whether to show GAAP EBIT or my estimate of true EBIT. Getting into the debate about SAAS valuations

    http://a16z.com/2014/05/13/understanding-saas-valuation-primer/

    would probably lead us into the weeds so best to just use 3 and be done with it.

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  5. From 2014AR: "activity within the German business has been managed down to a lower level, ensuring the business does not take any unnecessary risks. "

    From 1H15 Interims: "As expected, the steel sector in the UK and Europe has continued to face significant challenges and this continues to impact coke demand. Revenues from our German associate operation fell from £55.4m to £31.1m with an underlying operating profit of only £0.7m before the one-off settlement of a long standing legal claim which resulted in the operation breaking even during the period."

    So maybe not zero, but close to it?

    For UK Speciality, margin pressure is mentioned multiple times, as UK Coal works through their stocks & liquidates. 15/ton might be too harsh but 17/ton seems plausible (-10% from 18.82).

    Germany - 1.4m (annualized 1H)
    UK - 680 tons x 17/ton = 11.6m

    So 13m for good businesses in a low case. Seem reasonable?

    On the liquidation, if bulk coal & production goes away, i agree that a bunch of NWC frees up....but not sure how you are left with 12m EBIT in the other surviving businesses - just transport + industrial right? Which was 8m in 2014




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  6. red,

    Thanks for the link, I didn't think hard enough about that one before. Even with the risk of going into the weeds I'll go little further.

    I don't really have a proper idea of what the margins of that business could essentially look like in a normalized situation, so I'd be eager to hear your thoughts about it. Or am I in the right ballpark if I say you feel the true EBIT margin of the business once it matures would be around 40-50%? And in short, how did you arrive at your estimate of the true EBIT (in other words, how did you estimate the sales & marketing, R&D costs that are "prepaid")? Thanks again for your efforts.

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  7. I think 70% gross margin, 15% R&D & 9% steady state marketing is fair for SpendVision. Plus a proportional charge for admin and I think true EBIT is something like 13.

    Rev = 30
    Gross Profit = 21
    R&D = -4.5
    Admin charge -1
    Selling = -2.5

    Selling is where I think the difference is between steady state EBIT and GAAP EBIT.

    A thing like SpendVision should see ~90% retention and selling costs should therefore be low in steady state and high in the growth phase.

    Of course it's growing so revenue is understated because of the way that GAAP treats revenue recognition of SAAS business models, etc.

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  8. Thanks for coming back to this series. Will read and consider in more detail once I've looked into these companies myself. First thing to leap out at me is yclosing comment on Findel - any question of trust is a red flag for me.

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  9. Hey red, take a look at logicamms. A ausie engineering firm. 52m market cap, net cash of 22m, dividend. Another 7m of net current assets, and about 4.4m of NPAT last half year.

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  10. Great list. I own a couple of these already.

    I'd love to hear your thoughts on MS International. It's the most undervalued company in the UK right now in my opinion.

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  11. I know it well and I understand why you like it.

    MSI is so small, though, that one would have to depend on other private investors to take it off one's hands. And for that to happen, the div yield probably has to approach 7%+ or the forecourt business would have to take off.

    It's one of those stocks best bought after the news rather than before, imo. After the news the "share tipping" industry will promote it but only after a few days a fortnight of lag.

    Of course, if the objective is to get a total return in the mid teens than now -- when both defense and supermarkets are facing negative headlines -- is as good a time as any to buy,

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  12. Hey Red,

    Nice to see the US portfolio addition.

    I was hoping you could clarify which options on DFS you hold? I am seeing Jan 2017 55 strikes at over $10.

    I am guessing they are 65's, but thought I should clarify.

    TIA

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  13. Got my strikes mixed up. Sorry about that. Fixed.

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  14. I have little to add regarding the individual picks here. Regarding the overall UK investment environment though it seems you're far less positive than you were a couple of years ago. To my eye little of significance has changed in that time, is this just a change of perception or something deeper?

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  15. Well, the difference between then and now is that two years ago one could have screened for names and done well whereas one has to now read the reports or be already familiar with the companies.

    (Almost) everything that screens well today "has hair" or is a so-called "value trap".

    So this is the sort of period in which average long term return records are made or lost.

    Anyone involved at the bottom of a cycle will make lots of money. The question is whether one gives it back at or near the top of the cycle.

    When discount rates go up -- as I think it reasonable to expect sometime over the next two years -- the majority of shares trading at or near "fair value" will lose 10% to 30% of their value.

    Gain 50% and give back 20% is, I think, a recipe for mediocre returns.

    So one could either offset that by buying beneficiaries of an interest rate hike (banks are the usual suspects for those who like black boxes) or one could try to avoid the issue altogether by settling on a time arbitrage approach.

    So,I've tried to pick a mix of shares that (1) are out of favour because they're out of favour rather than because they're deeply flawed; or (2) that would benefit from a rate rise; and (3) that don't,as a group, depend too much on guesses about the direction of the macro variables or commodity prices.

    If a shake-out happens between now and then, I'll allocate that 20% cash reserve to something productive.

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  16. how do you get comfortable with the decline in FMCG for Thorntons? It seems mostly older people love these things. You are buying their argument that it is simply a matter of improving relations with supermarkets?

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  17. "Total Boxed Chocolate Market is now worth £746m up 2% from £731m last year"

    AC Nielsen Scantrack MAT Total Boxed Chocolate Sales to WE 31 January 2015

    Slide 42 of latest Investor Presentation

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  18. I see. And they are still ranked no 1. And they probably have a lot of wastefull spending which will likely be handled in the next 2 years. So take increased earnings, likely growing revenue, and put a 15x multiple on it, and you get 200% upside or more.

    And a possible play on interest rates as well with those pension liabilities attached?

    Thanks for the idea.

    Unrelated, but you have a model asia portfolio as well?

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  19. That's it, yes. Cash flow neutral for the next couple of years and FCF should approximate 0.15 per diluted share after that.

    I'll put up model portfolios for Europe and Asia in the next few.

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  20. Hey red since you look at general area's for idea's, how about dark fiber? Too much fiber networks were planted in the ground around the dotcom boom. And with explosive increase in smartphone and data use, they are starting to become more valuable now.

    Could be an interesting area to look for idea's?

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  21. Hey Red,

    I found it interesting to see THT in your main portfolio, but without a spot in the UK model.

    Did the recent results and price action significantly change the investment profile for you? I know timing is a focus area for you, is the expectation that price realization occurs sooner rather than later given recent results?

    Thanks for posting these model portfolios, they have provided me many hours of research topics. Liking the look of Key Tronic, Republic and Tsui Wah for further digging.

    Can't wait for the model EU portfolio!

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  22. I think I should sketch THT in a separate post but yes -- THT has been over-earning in the supermarket channel so the refusal to stock didn't come as an utter shock to me. I think it's a margin issue and volume will come back at slightly lower margins (for say, 21% EBITDA margin or so in the FMCG segment).

    On the other hand, SSS in the own store channel has stabilized. That's what I had been waiting for.

    If you look at the 2011 strategy document and focus on the discussion re the own store channel there are interesting glimpses as to what's going on.

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  23. Thoughts on emeco acqusition? The market seems to like it. Im curious though what kind of FCF it throws off. They only mention ebitda.

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  24. Road haulage businesses usually earn 20% EBIT margins. So $9m minus earnout payments = FCF.

    We'll have to wait and see how the performance targets underlying the earnout payments are structured.

    It's notable the sellers agreed to accept 20% of the consideration in the form of EHL shares.

    The investment case for EHL has metamorphosed, obviously.

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  25. Red what do you think of Outerwall's price increase? It seems like it could give a big boost to their FCF, making the stock potentially very cheap?

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  26. Hey red, wanted to share this:
    https://www.youtube.com/watch?v=t8QEOBgLBQU

    https://www.youtube.com/watch?v=jhgOqyZHBIU

    Think he has some interesting thoughts on how a lot of industries will change in the future, allthough wish he went more into detail.

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  27. Have you ever taken a look at ASOS? I know it's often cited as an example of market overheating, but I think online fashion might have some pretty great competitive dynamics on reflection.

    It has clear strengths over brick and mortar stores, especially fast fashion stores (eg Zara/H&M), in speed and cost. The market appreciates this, and gave it huge multiples up until the point where ASOS started encountering competition in the online space (Boohoo/Zalando).

    Thinking about it though, the moats in online fashion seem impressive, at least as ASOS operates. Beyond scale advantages in delivery, it seems that it is setting itself up more as a gateway to online fashion, with its own brand clothing, social media, customer trust and expanding market share serving as high switching costs, and then it makes profits in an Ebayesque way. This seems to be borne out in results: where it's competing for new customers (abroad) it's having to cut prices to win business but at home in the UK, the much more mature market, growth continues to be stellar. No reason to think that international won't follow suit. Also just the best run company in its niche so likely to win over new business for a while to come.

    Obviously very expensive, but the market's lack of appreciation of its incumbent advantages means that every tough quarter brings the price crashing down to attractive levels, so worth having on the radar. Also an argument that, like Amazon, it could make a lot more money if it wasn't trying to win new customers over.

    Any thoughts would be interesting to hear.

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  28. I think the clue is that you've outlined the relative strengths of online distribution of fashion rather than the strengths of ASOS in particular.

    Why will ASOS beat, say, Salando or Yoox?

    If online distribution offers advantages then why wouldn't Inditex get into that channel (in a big way) and if it does, how in the world does ASOS compete with that?

    In the end, we're talking about how today's 8 year-olds will buy clothes in 2025. There's a wide range of possible outcomes and I'm not sure that I'd pay 50x earnings (i.e. wait 10 years) to find out.

    In the short term, of course, the stock will react to half year acceleration/deceleration of the sales line. So it could work well as a trade. But (intrinsic) value is more than likely much lower than current market cap in my view.

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  29. But I think the essential thing is that online fashion, at least in the way that ASOS operates, is a business with incumbent advantages that bricks and mortar fashion doesn't have, and so if ASOS gets there first (which it probably will/is), even Inditex will struggle to compete.

    The basic premise would be that it's running what I'd interpret to be a Switchboard model (as explained in the Art of Profitability); it brings together multiple different specialist labels, its own Zara/Topmanish fast fashion brand and fashion content (bloggers, a magazine etc.) and shoppers come to rely on it as a gateway to fashion: sort of like a Mall/Department store model, but with much better barriers and much lower costs. Then it's a virtuous circle as it gains more and more leverage with suppliers which will lead to ever improving merchandise which leads to more customer capture etc. Ennismore have a good write-up here: http://www.ennismorefunds.com/documents/OEIC/Newsletters/2014/NL%20OEIC%20Sep%2014.pdf

    There is a question as to whether it will succeed in becoming the incumbent. Interestingly so far it's just about the only online website targeted at 'twentysomethings' fast fashion; Yoox is all designer and Zalando is far more middle-aged/kids targeted, which undermines its ability to compete (it hasn't even really being trying to all that aggressively with ASOS). Young people want well-modelled clothes targeted exclusively at them; the Zalando website is a little too German. Anyway, the market is still pretty huge so there's space for a few retailers targeted at different groups, and with the barriers to entry of the ASOS/Zalando model profits could be significant.

    As you say though: very high multiples, and predicting how clothes will be bought long into the future is tough.

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  30. Any thoughts on the departure of the Thortons CEO? When the case seems to rely on a successful execution of strategy and decent management, this seems a little worrying.

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  31. ^just saw your tweet, but yes it is odd...

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  32. Well congrats on Thorntons, that's a quick one. I supose at this point it is worth holding onto for the extra 1-2 pence?

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  33. Glad it worked out for us. Lowball bid but the speediness makes up for it. On to the next.

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  34. http://macaubusinessdaily.com/Business/Future-Bright-Tight%C2%A0timeframe-project-completion-Hengqin

    Article on Hengqin from Future Bright CEO. Thought you might be interested

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  35. Red, what's your country allocation strategy in terms of whole portfolio? I see you focused on EMEA.

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  36. Also, could you do a blog talking about stop loss in value investing?

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  37. I generally toward the fire -- sometimes countries or regions and sometimes sectors irrespective of country/region. Governance norms are important to me so never Russia, Japan, Korea etc

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