Adrian Williams, Alphameric, alternative assets, Argo Group, asset managers, Avangardco, Bear Stearns, binary outcomes, capital expenditure, catalyst, delisting risk, DM plc, Dresden, emerging markets, Expected Value, Fair Value, Fortress Investment Group, Gagfah, government regulation, intrinsic value, IRR, Joe Lewis, litigation, major sale, Net LTV, P/E ratio, P/S Ratio, risk aversion, risk management, share buyback, share repurchase, takeover offers, Timeweave
Continued from here, & here’s the first post in the series.
vi) Litigation/Regulation is the final catalyst on my list. It’s also, without a doubt, the most difficult to exploit & to write about (note I’ve tackled this series in reverse order)! In fact, if it doesn’t (immediately) appeal to you, I might perhaps discourage you from ever bothering with this catalyst? To some extent it suffers from the same issues/perceptions I highlighted with v) the Major Sale catalyst.
First, most litigation/regulation risk/events are simply part & parcel of normal corporate operating activity. For example, certain sectors are almost permanently marked down due to their increased risk level (perhaps something politicians like to mouth off about?!). These risks usually aren’t of any fresh/major significance to a company’s business model or valuation, and/or they’re routinely priced in anyway – they are not catalysts.
But occasionally a real game changer comes along… A lawsuit, or a regulatory change/threat/action/approval, that could prompt a major change in a company’s future intrinsic value. It may also cause a rapid/significant adjustment in the company’s current market cap. So how exactly do we separate out & identify such a catalyst vs. the merely hum-drum? A similar approach, like v), seems sensible – something like:
A litigation/regulation risk or event that may cause at least a 30-50% change in the intrinsic value and/or market cap. of a company may offer a significant catalyst.
Of course, this kind of existential threat (or possible opportunity) is difficult to handicap. I mean, the company may not even have a handle on it! Even if they do, they may prefer to wallow in denial, or simply remain unwilling to share the nitty-gritty risks/detail with shareholders, let alone the external world. And if you’re an investor who likes to research & take on this type of risk, in reality the outcome’s still always going to be binary – which can lead to v different financial results.
The correct approach with binary (or multiple) outcomes is, of course, to use an expected value approach: Identify each outcome, try to handicap its probability, evaluate the potential financial impact, and repeat... Once you’ve covered the spectrum of probability/outcomes, you can calculate the resulting expected value of the financial impact & consider it in relation to the current market cap.
If you’re a smart & consistent handicapper, you can reasonably expect to make good money over time. Trouble is, in the short term, you just can’t escape that actual binary outcome. Yep, you can put in all the research & judgement in the world, and still lose a shit-load on a particular stock situation. And that plain hurts! But remember, too many investors (even institutional) just don’t deal with, or price, this kind of situation v well… They end up pricing it in binary fashion:
i) They completely ignore the risk, they forget the risk, and/or they refuse to price in the risk*, or
ii) they just go completely overboard, and price in the majority (or even 100%) of the risk!
[* Very reminiscent of folks who couldn’t even imagine the risk, or the potential for a v different price, inherent in AAA paper in late 2007.]
When investors forget to use an expected value approach (or simply forget a risk altogether!), this is exactly the situation that may present a lower risk opportunity, ideally within an accelerated timeline… Yes, a catalyst! And these turn up more often than you might imagine. I’m sometimes amazed at the value on offer pre- & even post-catalyst. Of course, I’m not suggesting you make this your sole focus – that’s putting the cart before the horse! Let’s return to my original definition:
A catalyst is any kind of transaction/fact/event/etc., actual or potential, that offers the opportunity for a full/partial realization of value in a stock, within a (reasonably) accelerated timescale.
A catalyst’s basically about improving your investing Internal Rate of Return (IRR). If you buy into a company/share that’s not attractive or cheap enough, a catalyst may not assure your salvation..! But let’s not waffle on – as usual, examples are probably the best means of persuasion (or not..?!):
a) DM plc (formerly, DMP:LN): DM was a direct marketing group, specializing in customer recruitment & database management. For most businesses of this sort, customer recruitment’s the major expense (and requires constant re-investment & updating). It’s a competitive field, and clients who purchase the customer data are often much larger in size – so, consequently, margins are often tight. The beauty of DM was that Adrian Williams (Founder/Chairman) figured out the cost could be cut significantly by utilizing mobile/internet, and by offering competitions & draws requiring participation via premium pay phone lines.
Not my cup of tea, I’ll admit, but there’s plenty of punters who lap that up – thereby increasing response rates & lowering net costs! Occasionally, a paper would decry this approach, but I never noticed a wilful breach of the regulations. This amounted to a v tasty business with revenues of GBP 27.6 mio & operating profit of GBP 5.3 mio in 2010, for an OP margin of 19.1%!
However, things started going pear-shaped, with PhonepayPlus & the OFT targeting these types of promotions. This culminated in a judgement against DM in early 2011, which they promptly appealed (sent to the European Court of Justice as a test case). There was no fine, and legal costs were being expensed & provisioned by DM, but the court’s ruling demanded an abandonment of existing promotions & a dramatic change in DM’s recruitment model. Interim 2011 results showed a 38% decline in revenues to (an annualized) GBP 16.8 mio, on a much reduced 5.4% operating margin. Investors reacted violently, with shares driven down to a GBP 1.25-1.4p trading range in Q4-11 – a collapse in market cap. to GBP 2.3 mio, at best..!
This was ridiculous: DM was still generating profit, had a net cash position, no regulatory fine to pay, and I didn’t see a continuing threat to revenues. That is, presuming the required customer recruitment was restored to support those revenues – unfortunately, a permanent step-change in cost appeared to be necessary to produce that. However, Williams had a long history of taking over & rapidly turning-around loss-making companies. This offered confirmation he could, operationally & by acquisition, maintain/increase revenues (from their new lower level) & arrest/restore a decent portion of the lost operating margin. The eventual cessation of the ongoing legal costs would clearly assist also.
This was a no-brainer – a market cap. of GBP 2.3 mio, or less, vs. a medium/longer term return to an OP margin of, say 10-12% – which would reasonably support a 1.0 P/S valuation (GBP 16.8 mio)! Trading volume was terrible, but I did fill my boots as much as possible… Somewhat predictably, Williams then launched a bid (with a threatened de-listing) in Dec-11. But the offer was at GBP 1.8p per share in cash, a 44% premium, so no complaints here..! 🙂
[I was bemused to see a lawsuit recently cited as a potential negative catalyst in Joe Lewis’ Mayfair offer for Timeweave plc (TMW:LN). The offer was ridiculous enough – GBP 49.6 mio for a company with GBP 38.0 mio in net cash/investments & revenues of GBP 28.7 mio (at a 29.0% operating margin)! To specifically cite TMW‘s defence of a GBP 15.5 mio legal claim really took the fucking cake though!
This related to the sale of Alphameric Solutions for GBP 15.5 mio (any subsequent liability was limited to this total). More specifically, the claim was related to a 2006 software development agreement… Noting Alphameric spent less than GBP 1 mio a year on PPE/Intangibles, the sale consideration was completely irrelevant! It’s not hard to figure any reasonable revenue/profit impact estimate re a 6 yr old software contract is a mere fraction of that figure…
But congratulations, Joe, the threat of de-listing & compulsory acquisition seems to have done the trick – almost at the finish line now! A few more of these, on a larger scale, and you’ll no doubt earn back your Bear Stearns losses.]
b) Gagfah S.A. (GFJ:GR): Gagfah‘s one of Germany’s largest residential property companies, with a current portfolio of around 155,000 apartments. It’s actually controlled by Fortress Investment Group (FIG:US), a holding of mine – FIG has a majority of the BoD, and a major equity stake in the company.
In Mar-2011, the City of Dresden launched a lawsuit against Gagfah’s WOBA unit, which had acquired 45,000 units from the city in 2006, paying over EUR 1.7 billion. Numerous violations were cited of the sale agreement & the Social Charter protecting the rights of tenants, regulating among other things rent, repairs & maintenance requirements, and the tenant’s right to their housing. The lawsuit was for a whopping EUR 1.084 billion!
The market reacted predictably – declining 13% on the news from EUR 8.493 to EUR 7.41 per share, immediately wiping almost EUR 0.25 billion off Gagfah’s market cap! This merrily continued, with the share price reaching a nadir of EUR 3.25 in Aug-11 – amounting to almost a cumulative EUR 1.2 billion loss in market cap – actually in excess of the lawsuit total!? You’ve gotta be kidding:
This clearly illustrates my observation above – all too often investors either ignore a risk, or an expected risk value, or they flip over into pricing in the v worst/largest risk they can imagine. It’s one extreme, or another…
The average investor was trapped in the cobra’s gaze – they couldn’t see past, or imagine anything different to, this gigantic EUR 1.1 billion penalty. But of course it’s not a penalty, it’s just a bloody legal gambit! What could possibly deserve a penalty of almost two thirds of the original WOBA purchase price?! And let’s add some real perspective: That 1.1 bio’s more than double the equity invested in the purchase, at least 7 times the annual rent roll, over 8 times the capex. spent on the WOBA portfolio, about 12 times the value of the WOBA properties sold, and God knows what multiple of the portfolio’s actual annual net income. Take the most relevant of those figures, and also consider that presumably only a certain % of tenants could likely have been affected…
No matter how you model scenarios, or slice & dice the numbers, I don’t see how an actual penalty exceeding 5-10% (EUR 54-108 mio), of the total figure could possibly be ever ruled upon, appealed against, and actually collected on. And considering the financial situation of most Western cities these days, any kind of settlement would be like free money – incredibly tempting! Let’s take the top of the range & assess the potential impact: Gagfah’s EPRA NAV was EUR 12.19 – so EUR 108 mio would only knock 4% off NAV to EUR 11.71! And there’s no appreciable increase in financial risk either – Gagfah’s Loan-to-Value (LTV) ratio would increase by only 1.3%. Big deal..!
Lo & behold, a year later (Mar-12), Gagfah & Dresden announced a settlement. I estimate the total (including annual payments to Dresden, the city’s legal costs, and an increased capex. commitment) amounted to about EUR 46 mio, paid over nine years. So, in fact, only about 4% of the lawsuit, in the end! And here we are today: The share price has just closed at EUR 8.495 – an exact round-trip back from a 62% interim decline!
c) Argo Group (ARGO:LN): We can take a bit of a breather on Argo – it’s a current holding, and I’ve covered it a number of times before. The most relevant post’s here, which explains how/why I built my position in the face of a lawsuit that appeared to pose an existential threat to the company. In reality, it only ever had the remotest chance of progressing, let alone ever reaching a final judgement – for all the reasons I’ve detailed in my post.
Of course, a catalyst isn’t a guarantee either. Argo now trades at GBP 10.25p, about 22% below (allowing for the dividend) my original GBP 14.5p writeup price. This doesn’t particularly concern me. I originally suspected Argo was cheap mostly due to investor’s negative perception of the lawsuit. Now, a year after the appeals/dismissals, Argo still seems to be suffering the same hangover (from investors who still believe a lawsuit can hit at any time!?). But timing/impact can be unpredictable – ideally, a catalyst speeds things along, but I allow anywhere from months to two years (depending on the catalyst & the complexity) for a significant market response.
Therefore, for stocks with a catalyst, it’s wise to set a deadline (for Argo, I set a 2 yr deadline – i.e. Jun-2013) & have an advance game-plan if the catalyst fails to fire by then. In many cases, a plan to sell may prove the best bet – perhaps you’re stuck in a go-nowhere value trap? With Argo, I’m exposed to a v cheap stock offering me exposure to emerging markets & alternative fund management! Two exposures near & dear to my heart! All things being equal, I’m happy to retain Argo for its long-term exposure if this catalyst fails to provide any meaningful oomph in the next 8 months.
Don’t forget: Argo’s currently on a GBP 6.9 mio ($11.1 mio) market cap. For this, you get a colossal 51% discount on its $22.5 mio in cash/investments, zero debt, a profitable business (on an underlying basis), and an additional/significant intangible value for the fund management business in the event of a sale. The only thing missing is a resumption of their prior (aggressive) share repurchase programme. This would offer significant intrinsic value accretion per share for long-term shareholders.
I peg my latest Fair Value for ARGO at GBP 31.1p per share. That’s little changed from my last FV in May, but considering the recent share price decline it now offers a far superior 204% Upside Potential. I currently have a 4.7% portfolio stake.
d) Avangardco (AVGR:LN): It’s not all bad news, you know! There’s a flip side to all this litigation/regulation – perhaps you’re on the winning side of some litigation, or a competitor’s seriously harmed while you remain untouched, or perhaps we’re simply talking about regulation in terms of a new approval…
Let’s consider AVGR, another holding, which I last wrote about here. Based on their recent interims, Avangardo’s annual revenues are now $612.9 mio, while operating profit’s $261.9 mio. That gives us a 42.7% operating margin, on sales growth recently reported at +27% yoy. Despite this, at the latest $9.08 share price (a $580 mio market cap), the market’s only awarding AVGR a 0.95 Price/Sales multiple! The disconnect on earnings is even starker – latest 12 mth trailing net income’s at $222.7 mio, so AVGR’s on a rather mind-boggling 2.6 P/E ratio! And that’s against the latest earnings growth rate of +47% yoy.
Well, batter me egg whites – that’s pretty bloody tasty..!
Oh sure, the nay-sayers will yammer on about political risk & corporate governance. So, how well have they done with US & European political risk in the past few years?! And what corporate governance lapses have AVGR shareholders suffered to date? In fact, their Investor Relations effort is top-notch – far better than many Western companies! Sure, risks exist, of course – but you get an ultra-low share price & super-charged growth in return..!
AVGR doesn’t pose an increased financial risk either. While net interest’s now at 12.8% of operating profit, underlying risk’s far lower – results show net debt’s been wiped out, and now actually stands at $4.4 mio of net cash! This is explained by cash generated from operations of $327.2 mio & free cash flow of $138.0 mio. This is remarkable net cash generation for such a fast-growing company, particularly one with ambitious capex projects which remain on schedule.
Which leads me back to a v over-looked catalyst for Avangardco. Very simply: The company’s applied for, and is hopefully expecting, export & other necessary regulatory approvals from Russia & the EU. A significant portion of their capacity – for example, their new Avis & Chornobaivske facilities – is designed & specced. to comply with the highest international standards & with EU regulations on poultry keeping. Approval from one, or both, markets would be a definite game-changer, and would usher in a new wave of revenue/profit growth for the company & its shareholders. Clearly, that ain’t priced into the share price right now..!
Meanwhile, or in a worst-case scenario, the cheapness of the share price & business model offers defensive & offensive comfort: i) Based on recent (no EU/Russia) results, and the current share rating, it’s difficult to imagine non-approval causing any real price decline, and ii) Avangardco’s probably the lowest cost producer globally, its latest shell egg export revenues were up well over 3,000% yoy (from an admittedly small base), and it plans to almost double its export markets this year – therefore, new capacity coming online can be profitably directed outside EU/Russia, if necessary.
Considering the excellent progress with cash flows & net debt, share buybacks wouldn’t be a bad idea here also – and would likely generate some real bang for their buck. In fact, I suspect most investors didn’t notice a share buyback programme was approved this year for almost 8% of the company’s shares. My latest Fair Value for AVGR has ratcheted up accordingly to $31.83 per share, about 13% higher than my last FV in April. But again, we’ve seen a significant back-up in the share price – but this now offers a much improved 251% Upside Potential. I currently have a 2.4% portfolio stake.
And here ends my catalyst series…
I hope you’ve enjoyed it, and discovered a useful idea/tip or two? Actually, maybe one more post might make some sense – a round-up of the entire catalyst series? Hmm, we’ll have to see – maybe I’ll get around to it fairly soon!
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Wexboy, do you think there’s any risk of fraud in this company?
Which company, Rommel?!
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Regarding Avangardco, do you think there’s a chance that Mr Oleg Bakhmatyuk, who holds about 3/4 of the company (via ULF) will screw existing shareholders
They’ve mentioned a couple of times that ULF would do an IPO and AVGR shareholders would be offered the opportunity to convert into ULF.
Despite the political risk this is the only other big risk I see!
Anyway, they’re in they own world of cheapness.
Also I would expect margins to be pressured by rising grains prices because of the poor weather in the region. Nothing too serious though
disclosure: long AVGR
This was my recent reply to a reader:
‘But the hints so far from AVGR suggest its shareholders will be treated v fairly/almost preferentially – e.g. get to exchange their shares at market (or even a premium) price into Ukrlandfarming shares at its IPO price, which offers them participation in a larger/more diversified agri-business. But this may still be far away, and there’s half-a-dozen possible transactions, so let me just say: From my personal perspective, I believe Bakhmatyuk is playing the long game here – he wants to build/fund a far larger & more main-stream agri-business empire, which is listed in London (/NYC), and eventually earns a market or even a premium rating to reflect its growth & good governance. Screwing Avangardco shareholders just isn’t worth it here – treating them well, earning a reputation & sticking to his long-term plan is a far more lucrative strategy for him ultimately.’
Avangardco’s was protected from rising grain prices due to forward purchases etc. That will impact in due course though, presuming high prices remain – I haven’t particularly highlighted it, as I’d hope continued growth is capable of absorbing that pretty well. In fact, to expand on my comment AVGR’s the ‘lowest cost producer’:
The beauty of investing in the lowest cost producer is that they’re a great offensive & defensive stock – in good times they obviously do great, but in more difficult times they do well also as they can mercilessly under-cut & grab share from competitors who are hurting. I’ve been a regular investor in Ryanair for exactly that reason.
Yes, it’s funny. I really enjoy reading your articles in your non-clinical style.
By the way H1 Nav of Gagfah stands at 13.1 €.
Thanks, yes, readers generally seem to like the style – lucky for me, it might be the only style I have..!
Funnily enough, Seeking Alpha seem to have the opposite opinion – they really don’t seem to like a more expansive style & articles! I need to get on message – write articles about Apple, Facebook, and lists of overvalued US REITs..!
Considering the steady increase in German rents, current German bond yields, and ongoing flight to safety I’m surprised we haven’t seen more/larger property revaluations in the sector. A bit more/some ongoing catch-up is likely needed, I suspect – the YTD rally in the larger company share prices suggests investors generally expect that also.
regarding gagfah: It was not just a roundtrip. The company managed to opportunistically buy back shares via two tender offers far below NAV. The drop was also due to questions about refinancing of loans.
Yes, agreed, there was a changing share count/market cap/NAV – but I was just so bemused to see the same exact share price today as that quoted just before the lawsuit was announced! And yes, re-financing risk was clearly another issue – but the share price decline/advance clearly tracked the lawsuit announcements, and the lawsuit itself exacerbated the re-financing risk as long as it remained outstanding. Cheers.