2014 – The Great Irish Share Valuation Project (Part I)

Tags

Abbey plc, Aminex, Andor Technology, Connemara Mining Company, DCC, Irish shares, Irish Stock Exchange, Irish value investing, ISEQ, portfolio performance, Smurfit Kappa Group, TGISVP, The Great Irish Share Valuation Project, UDG Healthcare, US Oil & Gas

Thanks, I’ve received some great feedback & encouragement from readers in the past couple of weeks…so why not, let’s rock this TGISVP bitch all over again! Despite the exclusive focus on Irish stocks, I’m also hoping to see a lot of international readers checking in (& commenting) on these posts. For two good reasons, I hope:

i) Regardless of my individual price targets, many readers have highlighted their appreciation of the wide variety of valuation techniques & perspectives I’ve employed here across a broad spectrum of companies. I’ll try to place even more emphasis on the valuation process this year, so hopefully this project will prove interesting to a far wider readership.

ii) I mean, have you noticed the Irish market – it’s bloody on fire! The ISEQ was up +17.1% in 2012, and nearly doubled that return in 2013 (+33.6%) – um, like wow! And to top it all, my TGISVP portfolios actually out-performed the index, across the board in 2012 & on average in 2013. Uhoh, I think I’m scaring the value investors away…

However, it’s worth remembering I’ve been bullish on Irish stocks for a couple of years now – but a lot of investors really only started to pay attention last year. And much of the overseas interest to date, for example, has been primarily focused on (distressed) property & loans – rather than equities. So, arguably, we may only be reaching a point now where sentiment & interest in the Irish market’s fully blossoming. It’s also worth highlighting the rather unique economic & fiscal abyss the market’s rallying out of – in fact, the ISEQ remains 55% below its May-2007 highs.

Now, I hasten to add – I’m not actually making a specific ISEQ call here. I usually don’t think about indices in that manner (& often find the main indices too expensive anyway). I prefer to get comfortable with the current macro backdrop – as opposed to making macro predictions. [A fool’s game – noting current growth forecasts, and historical error ranges, all those highly-paid forecasters are really telling you is that developed market growth may be positive…or, um, negative!] Presuming a market passes enough macro hurdles, I’ll usually ignore the index & simply focus on stock-picking. Exactly as I’ll be doing here – though it will surely prove tempting to draw some overall market conclusion(s) near the end of the valuation stage (of this project).

But looking back at my recent Hot & Not snapshot/file, I do expect less bullish picks this year – I see I was (neutral to) positive on just a quarter of all TGISVP stocks. [Well, if I ignore most of the junior resource stock detritus, the ratio improves to almost 40%]. However, plenty of companies have enjoyed good operating progress in the past year, while others have experienced transformational events – net-net, this hopefully improves some valuations & my ratio of bullish stocks. Also, with fast improving sentiment & even some economic momentum, there’s an opportunity to selectively look back & incorporate prior peak operating margins/earnings as a component of some valuations. [I occasionally employ such a methodology for cyclical stocks – for example, CPL Resources & CRH. Hmmm, considering the last 5-6 years, maybe all Irish stocks should be considered cyclical!?] I honestly don’t know how applicable that approach might be, but I’m hoping it will throw up an interesting surprise or two…

Not to worry, though, I’ll still be marking the cards of dozens of crap companies, crap valuations, or both…and not just the junior resource shit sticks stocks, I suspect! No doubt, I’ll piss off just as many people & more this time ’round – aah, something to look forward to…  😉

OK, you probably know the rules of the road by now, but humour me. The first half of this post is still a good primer for the whole TGISVP project – but I’ll specifically note the following:

– An Irish company is any that conducts a major portion of its business in Ireland, or is genuinely headquartered in Ireland, and/or whose management (or directors, shareholders or history) are predominantly Irish.

– Yes, I’d love to cover all stocks simultaneously, but life (& investing) are never so convenient… I reckon there’s almost 80 companies to cover, so TGISVP posts will be spread over the next few months. And please note I’m tackling stocks in random order – just to make things a little more interesting!

– For each stock, I’ll include a website (link) & its most active ticker (many have secondary Irish/UK listings). I’ll also link to prior TGISVP posts etc. which are worth reading as additional reference.

– It’s worth reminding readers I wouldn’t dream of owning some of the stocks with the most upside potential – there’s other equally important quantitative & qualitative factors to consider before buying any stock. But I’ll highlight all stocks I actually own.

– Each post will include an (evolving) TGISVP Excel file with all figures & calculations – feel free to review, agree/disagree with my assumptions, and/or revise valuations for your own personal use.

– Most important, read my Disclaimer! This is a research exercise, designed to construct & track performance for a number of notional Alpha & Beta Portfolios. Plus all valuations are rough & ready – if I bought one of these stocks, I’d first perform far more detailed research. You should too!

OK, let’s begin:

Company:   DCC

Prior Post(s):   2012 & 2013

Ticker:   DCC:LN

Price:   GBP 2,765p

DCC’s UK migration is now complete, with GBP reporting & a London-only listing (though it’s retained an Irish HQ & tax-residency), reflecting the fact only 10% (or so) of profits are now Irish-generated. It also removes a large component of the FX noise shareholders have experienced over the years. Otherwise, DCC remains the same – a finely honed, but relatively conservative, acquisition machine. [In this instance, that’s a compliment!]

I’ve never found DCC particularly cheap, but it never really gets the respect it deserves either (i.e. to be wildly over-valued in my eyes!). The conglomerate tag’s still the bogey-man here – rather unfairly, as DCC boasts many of the advantages the original conglomerates enjoyed. But aside from more recent wobbles (which now appear over), DCC’s excellent performance has allowed management to ignore the (muted) calls for a break-up. Ironically, this excellence may now be catching up with them – Energy (oil & LPG distribution) & Environmental (which is, arguably, complementary) are now delivering almost two thirds of DCC’s profits. We’re fast reaching an end-point now where selling or spinning off the other divisions, and investing in an accelerated Energy roll-up strategy across Europe, will make far more compelling operational & financial sense. Selling Food & Beverage would be an obvious first step – this (struggling) pipsqueak now contributes just 3% of profits!

Over the past 19 years, operating profit’s enjoyed a 13.0% CAGR (versus a 14.7% CAGR for the dividend), while FY adjusted/diluted EPS is forecast to be up 13% yoy (I suspect we’ll see a little better). Mashing them together, I’m going to step it up a notch with a 15.0 Price/Earnings multiple. DCC’s adjusted operating profit margin is 1.9%, but operating free cash flow (cash generated from operations, less net capex/PPE) margin’s significantly better at 2.2% – a pattern that’s been repeated in the past few years. This justifies a 0.20 Price/Sales multiple.

[NB:  Noting market valuations (and M&A multiples) over the years, my rule of thumb is a 10-12.5% operating margin deserves a 1.0 P/S, on average. And higher margins justify an expanding multiple – for example, a 30% margin might deserve a 4.0-4.5 P/S multiple. Some people may find it hard to get their head ’round using this metric, so let’s look at it from a different perspective:  Assume Company X has 100 in revenue, and an 11 operating margin. This deserves a 1.0 P/S, so X’s valuation is 100. Now, let’s approach it another way – if we take the 11 operating margin, deduct 1 for net interest & 3 for a 30% tax rate, we end up with a 7 net profit. Applying an average long-term market P/E of 14, X’s valuation is 98 – (basically) equal to the P/S approach.

However, a P/S methodology’s more defensive than relying solely on a P/E valuation – which can be incredibly sensitive to small changes in assumptions (or actuals), as investors tend to inevitably & painfully discover… It’s also much closer to how corporate/private equity acquirers actually think about valuation – believe me, they don’t sit around worrying about P/E multiples (well, except when they’re pitching an IPO!). Some readers would obviously advocate a full-blown EV/EBITDA approach, but I think that presents its own set of problems – plus many investors are uncomfortable or unfamiliar with the methodology anyway].

Finally, I note net interest of 23.4 million, just 11.4% of adjusted operating profit. I’m comfortable with interest coverage of 6.7 times, or greater – i.e. 15%, or less, of (adjusted) EBIT. So DCC can leverage up with an additional 149 M of debt (assuming a 5% interest rate), without any kind of significant financial or valuation impact. [The math: (206.0 M Adj OP * 15% – 23.4 M Net Interest) / 5%]. This debt would have minimal cost & would immediately enhance earnings via acquisitions (or share buybacks, if appropriate). To be (somewhat) conservative, let’s haircut this incremental debt by 50% & include it as a (positive) debt adjustment to our P/S valuation. Averaging out our two valuations gives us:

(186.7p EPS * 15.0 P/E + (11,116 M Revenue *0.20 P/S + 149.2 M Debt Adjustment * 50%) / 83.8 M Shares) / 2 = GBP 2,771p

DCC looks fairly valued to me right now – although it’s worth remembering shareholders might still reasonably expect to earn, say, a 15% return in the next year (based on increased earnings).

Price Target:   GBP 2,771p

Upside/(Downside):   0%

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Company:   Andor Technology     (to be cancelled at cob Feb-20th)

Ticker:   AND:LN

Price:   GBP 526.5p

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Company:   Connemara Mining Company

Prior Post(s):   2012 & 2013

Ticker:   CON:LN

Price:   GBP 4.875p

Connemara’s a John Teeling vehicle – it drills holes in the ground for a living, ostensibly to discover gold or zinc. Sigh, I’m not sure I’ve got the energy for these junior resource stocks this year… 😦 But we can dispose of Connemara very easily – it hasn’t even got a whiff of resources, let alone reserves! So I’m going to commit the same misguided & short-sighted analytic errors as before – well, according to the muppet experts. [Two years of my price calls beating their asses now, you’d think they’d finally be embarrassed – um, too busy nursing their losses?!]

Actually, props to the muppet who despaired of me treating junior resource stocks as investment companies. Why thank you…what the fuck else do you think they are? [Hmmm, that’s possibly a very interesting post there]. And have you ever come across investment companies with such ridiculous expense ratios? The inevitable failure of the majority of these companies is down to simple math – not bad luck, as the suckers like to believe. Net cash, less net payables (if appropriate), less annual cash burn, is usually a good valuation methodology:

409 K Cash – 324 K Net Payables – 359 K Cash Burn = Zero

Suck on that, ya CONs…

Price Target:   Zero

Upside/(Downside):   (100)%

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Company:   US Oil & Gas

Prior Post(s):   2013, Other

Ticker:   USOP:G4

Price:   GBP 29p

That’s some luck of the draw! I didn’t expect to end up face-to-face with the USOPians so soon… But let’s be kind here – just take a quick look at the chart since my Sep-2012 post:

Yes, I know – forget the kudos, who could make fun of such liddle iddle widdle half-wits after such a calamity? I should really take the high road here – um, except there isn’t one… OK, after all the aqua-shenanigans in the past year, I’m no longer prepared to place any kind of value on USOP’s claimed resources. [OK, strictly speaking, there’s a lonely jar of oil sitting on a caravan shelf somewhere – but sorry, that just ain’t gonna move the damn needle]. That leaves us with a cash less annual cash burn valuation. Arguably, my burn rate’s a little aggressive, as it’s probably declined since mid-2013 – but in the end, that’s irrelevant:

2.0 M Cash – 5.2 M Annual Cash Burn = Zero

So, finally, it’s official – USOP is worthless. But it lives on across the message boards – hey, at least some of the USOPians got to meet other like-minded souls…maybe they can team up for their next luxury Vegas camping holiday.

Price Target:   Zero

Upside/(Downside):   (100)%

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Company:   UDG Healthcare

Prior Post(s):   2012 & 2013

Ticker:   UDG:LN

Price:   GBP 355.8p

Some might consider UDG Healthcare to be the DCC of the healthcare/pharma outsourcing sector – another acquisition machine. [Funnily enough, they’re now competitors to some extent, and UDG’s also migrated to a London-only listing – although it’s retained the EUR as its reporting currency]. And that was probably true many years back. But UDG isn’t so pretty when you look beneath the surface – there’s a lot more blood & guts… Two big problems:

First, management continues to pursue diversification at all costs. This is particularly annoying from a geographic perspective, with UDG now boasting a third of profits come from the US – all very well, if you prefer to ignore the fact they’re still a minnow in a very large lake. Now they’re even boasting of a Japanese presence – hmmm, perhaps management first developed a sushi habit visiting NYC?!

And second, I had a sneaking suspicion I should take a harsher look at UDG’s financials this year, and unfortunately this was justified. There’s a gigantic gap between IFRS & adjusted operating profit. The usual suspects are to blame – amortization, write-downs, exceptional & acquisition-related expenses, etc. – which I might accept on an isolated, or a case-by-case basis. But on average over the last 3 years, UDG’s operating free cash flow is barely over 60% of adjusted operating profit (which management obviously prefers to highlight). A capex spend that’s well in excess of depreciation is another culprit here, but I’m far less certain now of the prudence or the ultimate payback on that investment – so I’m definitely not going to make an exception for it.

Frankly, the real (underlying) problem here may simply be a never-ending erosion of margins (& even volume), as governments, the healthcare industry & large pharma companies all grapple with containing costs – which would certainly explain the problems as manifested above…

Let’s employ an approach similar to DCC – but in this instance, I’ll end up averaging out quite different perspectives & valuations. On the one hand, let’s rely on adjusted diluted EPS – noting UDG’s stumbles in more recent years, and earnings growth of 11% & 7% in the past two years (respectively), I see no reason to raise my 10 P/E multiple. On the other hand, I note a 4.7% adjusted operating margin last year (& 4.6% the prior year) – but as highlighted, this should be haircut by 39% to better reflect actual operating free cash flow. That’s an effective 2.8% margin, which I’ll award a 0.25 P/S multiple. Now, this means underlying interest coverage isn’t great either – I should probably haircut my P/S valuation accordingly, with a negative debt adjustment. But I’ll grant a free pass, this time ’round – anyway, UDG could actually pay down a significant portion of debt with cash on hand (174 M). This all averages out to:

(27.05 cts EPS * 10.0 P/E + 2,033 M Revenue *0.25 P/S / 241.3 M Shares) / 2 * 0.8206 EUR/GBP = GBP 197p

But investors are often happy to ignore underlying cash flows, and potentially diminishing returns, for long periods of time – so I may prove wide of the mark here. But upon mature reflection, UDG Healthcare definitely looks wildly over-valued to me. Don’t forget, as with all companies – if things ever start going (seriously) wrong here, that’s when investors will finally focus on the cash flow statement, see the lower underlying margins & potential interest coverage/debt risks, and join in as the share price spirals lower. Anyway, even if you still prefer a P/E valuation, how exactly do you justify UDG’s current 16 P/E based on its recent & likely earnings growth? [And that multiple’s based on adjusted diluted EPS – use actual diluted EPS, and you’re talking about a 37 P/E!?]

Price Target:   GBP 197p

Upside/(Downside):   (45)%

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Company:   Abbey

Prior Post(s):   2012 & 2013

Ticker:   ABBY:ID

Price:   EUR 10.80

Abbey’s been hunkered down for the past 6 years now, with the Gallaghers firmly in control with over 73% of the company. This defensive posture has actually served it well, in terms of surviving the housing/credit crisis – but now leaves shareholders with a fairly meagre return on equity (4.3% in the year ending Apr-2013). That’s not surprising though, when you note Abbey’s got almost EUR 61 M in cash & investments (plus zero debt) on its balance sheet. However, RoE’s expanding – current run-rate’s now 6.7% – and a better environment, plus some judicious leveraging of the balance sheet, should allow that to continue.

Historic financials might serve as a good road-map. Abbey’s RoE peaked far earlier than you might have expected – the two years ending Apr-2007 averaged 15.1% , while the three prior years delivered an average 25%+ RoE! That kind of scenario’s a little much to envisage right now, but a steady march higher back into the teens looks very achievable. For the moment, let’s split the difference & assume a 10.9% RoE can be squeezed out of Abbey with a little more effort. I’ll generally award a 1.0 Price/Book multiple for companies earning anywhere between an 8-12% Return on Equity – entirely dependent on the quality of the company & its business model, plus the degree of risk and/or leverage involved. In this case, I’d tag Abbey with a 1.2 P/B multiple:

175.4 M Net Equity * 1.2 P/B / 21.5 M Shares = EUR 9.78

Abbey looks slightly over-valued at this point. It’s a shame they’re almost entirely focused on UK land-banking & housebuilding – judging by the recent Green REIT (GRN:ID) & Hibernia REIT (HBRN:ID) premiums (to cash!?), an Abbey focused on Ireland would probably attract a far higher premium from investors. It will be interesting to see if the Gallaghers are tempted to return to Ireland…

Price Target:   EUR 9.78

Upside/(Downside):   (9)%

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Company:   Aminex

Prior Post(s):   2012 & 2013

Ticker:   AEX:LN

Price:   GBP 1p

Aminex performed beautifully last year:

Er, I obviously meant for me, not shareholders… My price target implied a 68% decline – and yes, I recall some (rather predictable) muppet disbelief. 😉 [They probably didn’t appreciate me comparing Aminex & its peers to a ‘meth whore‘ either]. The share price actually collapsed by 65%, and has managed a further 39% decline since year-end – what is this, a listed company, or a bloody clown car? Perhaps investors were disappointed with Thursday’s announcement of a placing & open offer of over a billion new shares at GBP 1p? Especially when it comes just 10 weeks after management stated ‘equity fund-raising…is not feasible at present’ (when AEX was at trading at 2p)! And I bet the realization existing shareholders will end up owning just 41% of the company must sting a little too.

The timing’s a little awkward here – I think it’s best to assume the placing & open offer will be completed (otherwise, there’s not much to analyze anyway!). Which means the outstanding share count gets bumped up from 819 M shares to 1,981 M shares, in exchange for:  i) The acquisition of Canyon Oil & Gas, a private company (in which Brian Hall, the Aminex Chairman, already has a small stake!). Tangible assets are negligible – the only real justification I see for the transaction was bringing Jay Bhattacherjee & Philip Thompson on-board as CEO & COO respectively, ii) the extinguishing of $1.3 M owed to industry creditors, and iii) the receipt of GBP 8.8 M, net of placing/offer expenses.

Now let’s tot up the company’s assets:  First, there’s $0.6 M of cash, plus another 0.3 M from the sale of its South Weslaco Field. Then there’s the GBP 8.8 M placing/open offer cash, but I’ve got to allow for $3.2 M committed to repaying other industry creditors. As regards actual oil & gas reserves, the cupboard’s somewhat bare… Despite all the excitement about Tanzania, there’s been a near-total lack of actual progress by the company – it’s far too early to ascribe any kind of substantial value to what are only classified as contingent & prospective resources to date. That just leaves the US onshore assets, which fortunately boast 1.5 M & 4.9 M boe of proved & probable reserves respectively. I usually assign a standard in-the-ground $10 per boe valuation for proved reserves, and haircut by 50% for probable reserves. [Onshore US assets might command a higher value, but that’s offset by the substantial % of natural gas reserves & the fact Aminex has a weak hand as a seller]. Finally, let’s not forget there’s 8.2 M of debt, and an annual cash-burn rate of 12.9 M:

(0.6 M Cash + 0.3 M Sale Proceeds + GBP 8.8 M Placing/Offer Proceeds * 1.6435 GBP/USD – 3.2 M Creditors + (1.5 M + 4.9 M * 50%) * $10 per boe – 8.2 M Debt – 12.9 Cash Burn) / 1.6435 GBP/USD / 1,981 Shares = GBP 1p

Well, blow me down – after the price collapse in the past year, Aminex is finally showing a sliver of upside at this point! Now, let’s see if they can avoid snatching defeat from the jaws of victory…

Price Target:   GBP 1p

Upside/(Downside):   4%

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Company:   Smurfit Kappa Group

Prior Post(s):   2012 & 2013

Ticker:   SKG:ID

Price:   EUR 17.40

Against a 2013 back-drop of tentative US growth, and an inflection point for European growth, Smurfit Kappa’s actually firing on all cylinders with 8% YTD sales growth & even better 10% growth in its Q3-2013 results. Of course, its Sep-2012 acquisition of Orange County Container Group made a substantial contribution – but its No. 1 & 2 positions (in Europe & globally) in corrugated packaging, for example, also yield benefits like continued margin expansion.

Now, as long as Smurfit remains over-indebted (accompanied by a substantial pension deficit), I’ll continue to focus on its cash flow (& balance sheet) statements – as I would with any ‘distressed’ company. Fortunately, operating free cash flow margin’s now reached 9.0%. Following 3 years of 8% margins, on average, that now justifies a bump-up to a 0.8 P/S multiple. However, interest (expense) coverage remains a skimpy 3.2 times. If we were to limit interest expense to 15% of operating FCF, that would require a reduction of interest expense from 220 M to 104.6 M – which would imply a near 53% reduction in the company’s excessive debt (& net derivatives) burden. Let’s haircut our P/S valuation accordingly. I’d normally adjust for Smurfit’s 0.7 billion pension deficit also, but here it’s almost perfectly offset by cash on hand – so let’s ignore both in our calculation:

(7,749 M Revenue * 0.80 P/S – 3,422 M Debt/Net Derivatives * 53%) / 229.5 M Shares = EUR 19.19

In spite of the major price rally in the past two years, Smurfit is still mildly under-valued. This is a good illustration of how quickly the valuation of ‘distressed’ companies can change. When such a company remains on a negative trajectory, investors grapple with the binary risk of survival, or disaster – at some point, to compensate, its market valuation will likely be marked-down far too aggressively. Ultimately, if the company looks like it’s steadily executing on a turn-around (and a debt pay-down schedule), its valuation will conversely enjoy mark-up gains well ahead of its underlying progress. Recent debt-refinancing, and further debt amortization, should hopefully offer further gains to come for SKG shareholders.

Price Target:   EUR 19.19

Upside/(Downside):   10%

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OK, that’s it for now, folks – I’ll obviously be back with another TGISVP post soon. Feel free to email or comment with any of your questions & feedback. Cheers! And here’s my first TGISVP file, for reference:

2014 – The Great Irish Share Valuation Project – Part I