Updating my earlier post on the Qantas bid, aside from anything else I just hope management don’t trip over themselves or any stray Alinta executives in their rush to take the company private!
The independent expert’s report values the airline anywhere from $5.18 to $5.98 thereby conveniently placing the midpoint 2 cents under the $5.60 bid price. Good work, Grant Samuel & Board. A bit of a wider valuation range than we might have expected at more than 7% either side of the midpoint, but fairly tidy.
Looking back I admit at being slightly amazed just how fast the Directors rolled over and allowed the consortium in with just a 2% (10 cent) increase of their $5.50 original bid (compare it to Coles). Then I read the AFR on Friday February 9 with all the gory details of the success fees coming after another profit upgrade and I really wonder: was anyone looking out for the shareholders in this transaction?
I must point out that I’m not against the deal per se but I think some of the lousy behaviour present in the markets nowadays is clearly evident in this case.
The only real hurdle to success now is the FIRB – due to rule by March 7 – and Peter Costello who can make a ‘national interest’ ruling. For interest, the FIRB have raised no objections to most takeovers in the past few years including Xstrata/MIM, Singapore Telecommunications/Optus, and the BHP/Billiton merger. Famously, the Shell/Woodside deal was knocked back by the Treasurer but I doubt it will happen in this case.
Showing posts with label stocks. Show all posts
Showing posts with label stocks. Show all posts
Monday, February 12, 2007
One for the watchlist
I like the concept of investing along a theme. It’s not new, but the strategy involves picking a trend then trying to spot companies exposed to the idea. You can often find a number of businesses in a particular market segment so either pick the best or spread your risk and buy everything. Two themes I’ve used successfully include agriculture – a contrarian play as the sector was then, as now, in the grips of drought – and smaller retailers who were expanding their store networks.
My latest theme is water, something very topical at the moment: we even have a new
Federal Minister for Environment and Water Resources while there have been some research papers on the economics of water released in the last few months. For one example, see ANZ’s Water use and regulation.
Regardless of what happens to control of the Murray River it’s very likely that there will be more construction of water treatment plants for recycling and desalination. While household consumption of recycled water will be some time off, industrial users won’t be too far away if the costs stack up. Companies with proven expertise in these projects should be front runners to pick up some business, while there will also be opportunities for companies who supply and install pipes. Some of the obvious candidates who should benefit from new projects are listed below:
But these are all bigger companies and it would take a few large projects to make a real difference to long term value. I like the idea of tackling some of the smaller players who might be more leveraged to new projects, and one that came up was Cardno (CDD), a firm with a background in engineering consulting but these days also involved in international assistance programs. If you know a little about Coffey (COF) you’ll find Cardno’s story familiar.
Cardno came to my attention through its involvement in the Gold Coast desalination plant but they are also working on the privatisation of the Abu Dhabi Sewerage Service in the UAE amongst other water-related things. If we start thinking about what Australia will need to do with water, these are exactly the type of skills required.
Their market cap is about $300M so maybe two-thirds that of Coffey and generating revenue close to $200M. Unfortunately it’s priced for growth with a capital G. I calculate Cardno needs average growth in earnings of around 17% over the next 10 years to justify current pricing of $6.12 or so. With the number of acquisitions undertaken in the last few years it’s not necessarily impossible but it’s also a big ask. That’s a shame, late last year it was under $5.00 and would have been a good pick up.
I like the mix of businesses which looks nicely diversified across different sectors making direct competition tricky. I like the skillset they own with the experiences gained overseas easily transferable to wherever growth is occurring and I think the specialised consulting services industry is quite fragmented providing opportunities to mop up and eventually expand margins.
One of the problems this type business can face is that while growing quickly they often chew up enormous amounts of working capital, a function of the accounts payable cycle (think wages, contractors etc) being a lot shorter than the collection cycle which on large projects can be measured in months rather than days. As a consequence, they are more likely to tap the markets for an equity top up and profit growth can’t always match revenue growth because of growing interest expenses. In Cardno’s case gearing is reasonable at 55% (June 06 figure, net debt) but interest cover is good at more than 5x so they could take on a bit more debt. Once the growth phase slows and investment in working capital stabilises the firm should be able to generate more surplus cash and paydown debt fairly quickly.
I think it’s expensive at over $6.00 having run up strongly in the past couple of months but I’m interested enough to add it to the watchlist and keep working on my research. If the growth embedded in the price comes back to low-mid double digits or new information comes to light I’ll be interested.
My latest theme is water, something very topical at the moment: we even have a new
Federal Minister for Environment and Water Resources while there have been some research papers on the economics of water released in the last few months. For one example, see ANZ’s Water use and regulation.
Regardless of what happens to control of the Murray River it’s very likely that there will be more construction of water treatment plants for recycling and desalination. While household consumption of recycled water will be some time off, industrial users won’t be too far away if the costs stack up. Companies with proven expertise in these projects should be front runners to pick up some business, while there will also be opportunities for companies who supply and install pipes. Some of the obvious candidates who should benefit from new projects are listed below:
- Leighton
- Multiplex
- United Group
- Transfield Services
- GUD
But these are all bigger companies and it would take a few large projects to make a real difference to long term value. I like the idea of tackling some of the smaller players who might be more leveraged to new projects, and one that came up was Cardno (CDD), a firm with a background in engineering consulting but these days also involved in international assistance programs. If you know a little about Coffey (COF) you’ll find Cardno’s story familiar.
Cardno came to my attention through its involvement in the Gold Coast desalination plant but they are also working on the privatisation of the Abu Dhabi Sewerage Service in the UAE amongst other water-related things. If we start thinking about what Australia will need to do with water, these are exactly the type of skills required.
Their market cap is about $300M so maybe two-thirds that of Coffey and generating revenue close to $200M. Unfortunately it’s priced for growth with a capital G. I calculate Cardno needs average growth in earnings of around 17% over the next 10 years to justify current pricing of $6.12 or so. With the number of acquisitions undertaken in the last few years it’s not necessarily impossible but it’s also a big ask. That’s a shame, late last year it was under $5.00 and would have been a good pick up.
I like the mix of businesses which looks nicely diversified across different sectors making direct competition tricky. I like the skillset they own with the experiences gained overseas easily transferable to wherever growth is occurring and I think the specialised consulting services industry is quite fragmented providing opportunities to mop up and eventually expand margins.
One of the problems this type business can face is that while growing quickly they often chew up enormous amounts of working capital, a function of the accounts payable cycle (think wages, contractors etc) being a lot shorter than the collection cycle which on large projects can be measured in months rather than days. As a consequence, they are more likely to tap the markets for an equity top up and profit growth can’t always match revenue growth because of growing interest expenses. In Cardno’s case gearing is reasonable at 55% (June 06 figure, net debt) but interest cover is good at more than 5x so they could take on a bit more debt. Once the growth phase slows and investment in working capital stabilises the firm should be able to generate more surplus cash and paydown debt fairly quickly.
I think it’s expensive at over $6.00 having run up strongly in the past couple of months but I’m interested enough to add it to the watchlist and keep working on my research. If the growth embedded in the price comes back to low-mid double digits or new information comes to light I’ll be interested.
Tuesday, February 6, 2007
Qantas bid price versus market
Investors betting that the Qantas deal will go ahead might be a bit more cautious this week following the bidders’ announcement they will voluntarily seek Government approval.
Since the bid was announced Qantas has traded at around a 5% discount to the $5.60 offer price. This discount mostly reflects the time value of money – buy the stock now at $5.37 or thereabouts and receive your money after the offer closes in March (or later if extended) – but also takes into account some uncertainty about whether the bid will actually go ahead.
For an investor thinking about arbitraging between the market price and the bid price it’s important to think about the possible downside risks compared to the fairly small upside. Consider Coles’ share price after they announced on October 19, 2006 the rejection of KKR’s buyout offer: down 9% in one day.
Looking at Qantas’ previous trading levels and operational performance a 9-10% fall seems to be a reasonable estimate of the downside should the bid fail, whereas the upside seems limited to perhaps 4% at last week’s close. While a Government inquiry into the bid shouldn’t result in failure it might extend the amount of time taken for the bid to go through and that makes the upside look even worse. It’s a classic ‘time value of money’ problem: would you rather have your $5.60 a share in 2 months or 4 months?
These factors explain why the market price hasn’t yet traded up to the bid level. As we get closer to conclusion they should converge.
Since the bid was announced Qantas has traded at around a 5% discount to the $5.60 offer price. This discount mostly reflects the time value of money – buy the stock now at $5.37 or thereabouts and receive your money after the offer closes in March (or later if extended) – but also takes into account some uncertainty about whether the bid will actually go ahead.
For an investor thinking about arbitraging between the market price and the bid price it’s important to think about the possible downside risks compared to the fairly small upside. Consider Coles’ share price after they announced on October 19, 2006 the rejection of KKR’s buyout offer: down 9% in one day.
Looking at Qantas’ previous trading levels and operational performance a 9-10% fall seems to be a reasonable estimate of the downside should the bid fail, whereas the upside seems limited to perhaps 4% at last week’s close. While a Government inquiry into the bid shouldn’t result in failure it might extend the amount of time taken for the bid to go through and that makes the upside look even worse. It’s a classic ‘time value of money’ problem: would you rather have your $5.60 a share in 2 months or 4 months?
These factors explain why the market price hasn’t yet traded up to the bid level. As we get closer to conclusion they should converge.
Saturday, February 3, 2007
Why I sold one of my small cap stocks this week
This week I sold out of one of my small cap stocks, a small Australian manufacturer. I bought into them in December 2005, attracted by strong dividends – a yield of 10%, fully franked – that were fairly well covered by earnings, and my assessment the shares were worth perhaps 95 cents instead of the 76 cents I paid. This assessment was made using an EBIT multiple relative to similar companies. In hindsight I think it was flawed and I should have used DCF (see an earlier post for more info.
Growth prospects were reasonably good in their sector and in adjacent markets; the company possessed some new technology that customers were in the process of adopting.
Of course, high yield generally reflects higher risk and this case was no different. Two customers – notorious hard cases for their suppliers – represented 80% of revenue. But the firm was diversifying and actively growing alternate revenue streams from ‘bolt on’ acquisitions.
I saw the yield as my reserve chute; even if the capital gains didn’t materialise in the next 12 months I could be happy to sit on it provided the yield wasn’t put at risk.
However patience finally got the better of me. In late January – 3 or 4 weeks from the next reporting date – the dreaded asterisk next to the stock code…and the “trading update” header on the announcement. Yep, profits going to be down for various reasons, and dividend to be cut. Since that was my primary reason for holding the stock I put the sell order in straight away, but not before it had lost 10%. Luckily, it had put on some capital gain recently and the 10% brought it back, literally, to my entry level. I made a grand capital gain of $0.35, but also kept my dividends which gave me an IRR on the stock of about 13%. It’s not a wipeout by any stretch but the market’s put on over 20% in the same time frame and I did have two opportunities to get out close to 90 cents but greed got the better of me.
I’m reminded of some important pieces of investment wisdom – taking these on board earlier would have resulted in a tidy overall return, ahead of the market.
Overall a good reminder and I was lucky to still come off in front.
Growth prospects were reasonably good in their sector and in adjacent markets; the company possessed some new technology that customers were in the process of adopting.
Of course, high yield generally reflects higher risk and this case was no different. Two customers – notorious hard cases for their suppliers – represented 80% of revenue. But the firm was diversifying and actively growing alternate revenue streams from ‘bolt on’ acquisitions.
I saw the yield as my reserve chute; even if the capital gains didn’t materialise in the next 12 months I could be happy to sit on it provided the yield wasn’t put at risk.
However patience finally got the better of me. In late January – 3 or 4 weeks from the next reporting date – the dreaded asterisk next to the stock code…and the “trading update” header on the announcement. Yep, profits going to be down for various reasons, and dividend to be cut. Since that was my primary reason for holding the stock I put the sell order in straight away, but not before it had lost 10%. Luckily, it had put on some capital gain recently and the 10% brought it back, literally, to my entry level. I made a grand capital gain of $0.35, but also kept my dividends which gave me an IRR on the stock of about 13%. It’s not a wipeout by any stretch but the market’s put on over 20% in the same time frame and I did have two opportunities to get out close to 90 cents but greed got the better of me.
I’m reminded of some important pieces of investment wisdom – taking these on board earlier would have resulted in a tidy overall return, ahead of the market.
- Don’t buy businesses with bad economics – this particular case the company didn’t have any pricing power with their suppliers and were forced to increase their working capital quite a bit (i.e. using up more cash) when one of the major customers simply decided to lengthen payment terms
- If your primary reasons for holding a stock or position change, then change your position
- Cross check your valuation – whether it’s with a broker’s report or by using another method, don’t just rely on multiples or DCF
Overall a good reminder and I was lucky to still come off in front.
Tuesday, January 23, 2007
BHP - what's it worth?
Looking up BHP I’ve found that of 15 brokers submitting their estimates to Thomson Financial, 6 have it as a ‘strong buy’, 7 as a ‘moderate buy’ and 2 say ‘hold’. The median EPS forecast for 2007 is 286.3 rising to 294.2 for 2008. So it looks like that BHP, trading at $25.33, is on a forward PE of just 8.8x. By comparison,
Yet BHP has underperformed the All Ords in the last 12 months – yes, in one hell of a commodities boom, the chief commodity company on the bourse hasn’t delivered a market return. And it’s not just underperformance, BHP shares basically haven’t moved since Jan-06 while the market has put on perhaps 18-20% (BHP in blue, All Ords in red in graph below from Yahoo Finance)
There could be a few reasons for this. Maybe it’s just cheap, taking a breather after performing well the prior year, or is this just indicative of a market at the top of the cycle where PE ratios are low because the market doesn’t think earnings are sustainable. I am probably leaning toward the latter.
One of my favourite tactics when assessing if a company is cheap or not is to reverse engineer the share price, that is, what sort of growth rate is factored into the current price? I was at a presentation from Investors Mutual where they talked about how they use a variant of this strategy and identified that stocks like CSL and Brambles were effectively priced for 0% sales growth over the next 10 years. I’ve also used it successfully for stocks such as Super Cheap Auto recently and, believe it or not, Telstra.
I’ve used figures from a major institutional broker as the backbone of my own ‘back of the envelope’ calculations for BHP (note that the broker’s DCF valuation for BHP is $20.92 and they have a ‘neutral’ rating). Anyway, using the broker’s figures out to 2011 as a base then applying a simple growth factor beyond, and calculating a terminal value, it tells us that to justify a price of $25.33, BHP only needs to grow free cash by 2.5% p.a. from 2007 to 2016 (assuming an AUD/USD rate of 0.7850). Increasing the annual growth of free cash flow over the period to 3.5% increases the current value to $26.85 or +6%.
These aren’t demanding growth targets but commodities are by nature a volatile market; witness the large swings in prices of copper, for example, on a regular basis. I’ll be keeping an eye on the former Big Australian to see how things pan out. Maybe the shares will outperform in 2007, keeping the tipsters in bread and soup for another year.
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