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Continued from here:

Right, let’s work our way through another batch of 10 stock valuations. As usual, I’ve updated market prices (and any relevant FX rates) for all stocks covered to date, so remember that each new file published will be a dynamic snapshot of each stock’s upside/downside potential:

The Great Irish Share Valuation Project III     (xlsx file)

The Great Irish Share Valuation Project III     (xls file)

ICON (ICLR:US):   ICON’s at a very interesting point right now. In 2009, they pretty much hit the wall, probably a reflection of the mid-life crisis that most of the major pharma companies are suffering right now. This is a pattern I’ve seen before – and forget to check up on nearly every bloody time (and, of course, it’s far easier to spot with hindsight!):

This is where Revenues slow down dramatically (only 2.6% growth in 2009), but Operating Profit (and perhaps EPS) still manages to bound along pretty sharpish. Seems like there’s that little bit extra in the tank, and management can pull a few rabbits out of the hat, to keep profits defying gravity that little bit longer… Wile E. Coyote comes to mind.

Another version of this story might be First Derivatives (FDP:LN). I didn’t cover them in my last TGISVP post, as the stock appears fairly valued. But this v much reflects an uneasy compromise based mostly on its previous stellar growth record. What alarms me is the continuing and relentless decline in their operating profit margins. Sure, trading margin for growth can be a net plus, but this feels familiar – far too often it turns out management was obsessed with revenues and scale, while the underlying business was really sucking wind. And then, on occasion, it all catches up…and a year or two of real reckoning is needed. We shall have to see.

More generally, operating profit should closely track revenues over time (albeit at a slightly faster pace). And, of course, EPS should in turn track operating profit (at a slightly faster pace too). Operating cashflow and free cashflow are more volatile (and depend on the maturity of the business, and/or stage of the economic cycle), but should also follow in their footsteps over time. I can’t stress this enough – yes, all v obvious…but I really need to check up on this type of thing much more systematically!

If you see a major disconnect in respective trends, make it a priority to get to the bottom of it! There may be a perfectly good reason, but it serves you well to be a little suspicious and to adjust your risk/reward expectations accordingly. Remember, applying the Napoleonic Code may not be so great for the accused, but can certainly be a blessing to the investor!

Right, back to ICON: The spectacular lack of R&D success big pharma’s had in the past 5-10 years (please, don’t talk to me about f**king lifestyle drugs…) is a secular trend working against ICON. Then again, there also exist a couple of factors that encourage outsourcing to Clinical Development outfits. At this point, ICON may have to rely more heavily on grabbing market share to create renewed growth and economies of scale. And this is exactly what seems to be happening, with v big multi-year contract wins from Pfizer (PFE:US), Bristol-Myers Squibb (BMY:US) and Shire (SHP:LN) in the past year.

Actually, hiring for the ramp-up in this business has further crushed operating profit margins (down to 0.5% in the latest quarter). But once these contracts are up and running properly, ICON will be firing on all cylinders and will return to/exceed its prior operating profit margins… Well, that’s the assumption – but there’s still a lot of risk involved at this stage, and the future profitability of this business is not totally clear. Even applying a reasonably generous valuation on the business, to reflect the assumption that ICON will bounce back to its LT average margin, it’s obvious that the market has opted for a rosier scenario…

I’m not comfortable with that – as with any stock, even if you see/believe in an optimistic growth scenario, your valuation should still be limited by the risk, timeline and uncertainties involved. If you follow some of the best (value) investors, they seem to manage to invest in situations where the current/historical facts and figures already stack the deck in their favour – they don’t need to rely on the future to bail them out…

IFG Group (IFP:ID):   I’ve written about IFG before, most recently here. To recap, IFG looked marvelously cheap on an adjusted diluted EPS basis, but I could never reconcile the figures back to Operating Free Cashflow. And this wasn’t down to the usual annual issue of cashflow volatility – in fact, each year’s operating FCF tracked fairly closely to the 13.9% LT average. The only logical thing to do was to arrive at a fair valuation based more accurately upon operating FCFs – which turned out to be where the IFG share price crashed on the news the Bregal takeover had been called off.

Irish Life & Permanent (IPM:ID):   Well, IL&P turned out to be more like B/I (BKIR:ID), rather than AIB (ALBK:ID), in terms of valuation. You know, I was surprised too! Ignoring AIB’s absurd market cap, in general the three banks are technically v well capitalized right now. This, of course, reflects the assumptions of PCAR exercise etc., which has to now unfold in the real world. It still shocks me that the implied losses from this exercise (or even my own back of the envelope losses) are significantly greater than each bank’s current provisioning. How exactly do management, or their bloody auditors, have any f**king shred of credibility when faced with that?! Oh, right, silly question…

I mentioned before that I avoided invested in the Irish banks for the past 5-6 years – I was too aghast at their loan-to-deposit ratios. What I forgot to mention was something even simpler, and scarier: Every time I’d read their reports I’d get a headache, but I would be suitably impressed. Except…erm, how do I explain it? Let’s put it into words even an AIB banker would understand:

If you’re going to lend half a million quid to a guy who has a rather amazing singing dancing duck, you better be damn well sure that the duck will do a Liza Minelli in Cabaret every night from here to eternity. Because otherwise, if it ever starts to just walk like a duck and quack like a duck again…you’re going to be really fucked…

I just couldn’t get past this – in many instances, if something fell through in even a small minority of cases, the collateral the bank had against the loan would be an utter joke. Loan-to-value ratios would, of course, also be an absurdly fictional source of comfort in a worst case scenario. Nobody could explain away this to me – it certainly wasn’t provisioned for, which implied they either ignored the risk, or simply didn’t even notice it to begin with. And I was just thinking about simple duck lending! Property development lending was obviously far more complex, and far more risky… This looked like a bad martingale bet.

Anyway: Again, can I remind you that my valuation, or even all that current excess capital, could be junked by a further increase in impaired/past due loans. Irish banks still present a very binary bet. Another thing to note is the level of pre-impairment profitability in each bank. Don’t worry, this won’t be hard to keep an eye on…it’s all the banks will want to talk about!

On this score, B/I probably has the edge, as IL&P is only breaking even by this measure. If they can address this cost:income imbalance – realistically, that implies they fire people – they will be creating a potential cushion to absorb any additional losses, and this would also be the key to ultimately seeing the stock trading at a premium to its (eventual) book value.

ISEQ 20 ETF (IETF:ID):  Perhaps I’m being a little unfair putting a 0% upside on the ISEQ ETF… When I value an investment company, I might see significant upside based on a high discount to NAV, but I don’t anticipate a market rise in my valuation. This upside generally doesn’t exist with ETFs, so they’re usually not my first/preferred choice. When I approach the end of this exercise, though, I’m hoping that some of the valuation averages provided will give a good pointer to the market potential of this ETF.

Independent News & Media (INM:ID):   I just have one little observation here – ‘Never invest in an O’Reilly company!’

Karelian Diamond Resources (KDR:LN):   Sigh, another Richard Conroy company. A little more than 1 year of cash on hand, nothing tangible to show for it. And if anything ever does turn up, it will take plenty of cash and a colossal dilution of existing shareholders to ever develop it…

Kenmare Resources (KMR:LN):   My hat comes off to the Carvills. The Moma mine truly was a huge undertaking, and I’m amazed they ever managed to pull it off. I had always, wrongly, presumed that Kenmare would eventually collapse and/or one of the majors would swoop in to complete/operate this project. I’m also amazed at the level of financing the banks have been willing to cough up, it feels just like 2007!

This was a tough one to value – I wasn’t that familiar with current, or historic, mineral sands prices and there’s not that much detailed info. out there. In the end, I established some representative medium term prices (Zircon $800, Rutile $500, Ilmenite $100 per tonne), which have been far surpassed in the past year or two. I’m not prepared to just jump to current price levels, so I’ve added a third of the recent price premium to my medium term prices. I then apply a rule of thumb that I arrived at somewhat accidentally (after tracking acquisition multiples, DCF analyses etc.):

Proved Reserves in the ground can be valued at 10% of the current spot price (or the medium term price, or a combination of both, if the spot price is volatile and/or perceived to be exceptional). Think of the most common examples: The oil spot price is about $100, while a proved boe in the ground is usually worth about $10. Gold trades at $1,600+, while a proved oz of gold is usually valued at about $150. Probable Reserves can be valued in the same way, but with a 50% haircut, while Measured/Indicated Resources should only be included (with a 75% haircut) occasionally in your valuation.

Putting all this together, plus cash and debt…I’m obviously perplexed by the valuation the market puts on Kenmare. We can debate reserve and resource valuations all day long, but let’s just think about Kenmare as a regular operating company for a minute. It’s current revenue run rate is about $112 million, while operating profit is about $20 million. Against this, we have a whopping $28.8 mio net interest expense bill! Let’s completely ignore any additional cash outflows to fund capex, Kenmare can’t even cover its interest bill! How did the banks end up here? Oh, right, another silly question…

Yeah, I’m sure production will continue to ramp up, and Kenmare’s received pricing has to catch up with the spot market… But let’s assume Kenmare reaches a point whereby its debt and its interest bill are actually sustainable. What would that take? I would say net interest should not exceed 15% of operating profit (6.7 times interest coverage) at a bare minimum. How do we get there? Well, if we assume that the operating profit margin expands from 18% to 30%, and revenues almost sextuple to $641 million, we’d actually reach that sustainability point.

Those are pretty heroic assumptions I think, and you have to wonder how quickly the company could ever get there? Even if they did, and you value the company at an appropriate P/E and/or P/S multiple based on those metrics, I’d be hard pressed to come up with a valuation much higher than today’s market price. So, there’s a hell of a lot discounted in today’s share price, far into the future, and very little potential reward unless things develop even more drastically that I’ve highlighted. It’s not for me.

Kerry Group (KYG:ID):   This stock has always mystified me too. In the past decade earnings have compounded at 9.25%, while in the past 4-5 years they’ve been even lower at an 8.1% CAGR. I shouldn’t be particularly surprised at this, I guess – revenues have only grown 2.3% per annum in the past 5 years, despite the acquisitions they have done along the way! Clearly, something is rotten in the kingdom..!?

Despite all this, the stock has always enjoyed a premium rating (it currently stands at a 13.8 P/E multiple). It’s always referred to as a blue chip, and while this may be true, the stock does not appear to deserve the market price of its shares most of the time (including now).

Any feedback, or questions, please don’t hesitate to comment or email me. Cheers!

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