I expect Argo Group (ARGO:LN) will be releasing interim results in the next week or so. I’ve no desire to be a hostage to fortune, but I think we can make some intelligent assumptions about their results – and there’s an important issue I want to highlight:
Let’s begin with Assets Under Management (AUM). First, I obviously have no idea re subscriptions/redemptions! But rightly or wrongly, my impression is that changes in Argo’s AUM have been driven primarily by performance, at least in the past couple of years. [NB: See here – at our meeting earlier this year, Andreas Rialas committed to better disclosure re changes in AUM – breaking out gross subscriptions, performance & gross redemptions is standard practice for the majority of Argo’s listed peers].
I also have no insight into the performance of the Argo Special Situations Fund (SSF) – let’s assume AUM remains unchanged. We then have the Argo Real Estate Opportunities Fund (AREO:LN) – which last reported an adjusted NAV of EUR 68.5 mio. For Argo’s other funds, I’ve come across conflicting reports of YTD returns – I prefer to be conservative, so I’m fairly confident we’ll see the following returns (as of end-June 2013), at a minimum:
The Argo Fund (TAF): +8.6%
Argo Distressed Credit Fund (ADCF): +11.9%
Argo Local Markets Fund (ALMF): (5.3)%
Which would imply the following AUMs:
The Argo Fund: $93.8 mio
Argo Distressed Credit Fund: $34.5 m
Argo Special Situations Fund: $110.3 m
Argo Local Markets Fund: $6.2 m
Argo Real Estate Opportunities Fund: $89.1 m
That would place total AUM at $333.8 m – all other things being equal – an increase of 2% since yr-end, and a nice 10% y-o-y.
Next, let’s consider Cash & Investments. Yr-end cash was $5.1 m, and let’s assume free cashflow is unchanged vs. last year at $151 K. [Which should offer some upside – i) receivables (ex-AREO) & payables were a significant negative last year, ii) management fees should be up y-o-y, and iii) further cost savings & efficiencies were identified in the final results]. Let’s deduct $104 K & EUR 20 K of Cyprus deposits. [Obviously they’re not a complete loss – I’m simply assuming the remaining balances get re-recorded to non-current assets]. We also need to deduct the dividend of GBP 877 K, or approx. $1.3 m. Assuming no other cash movements, this should place cash around $3.9 m.
For investments, I’ll assume no change in the SSF holding of $112 K. The AREO share price has fallen from EUR 0.0522 to EUR 0.02, slashing the value of Argo’s stake by about $0.5 m (to $0.3 m). However, we should also see the $17.6 m stake in TAF increase to $19.1 m. [Considering the value of this holding exceeds Argo’s entire market cap, it’s worth noting Andreas Rialas also committed to improving the level of disclosure re TAF]. This should place total investments around $19.5 m. I therefore calculate:
$3.9 m Cash + $19.5 m Investments = $23.4 m / 67.4 m Shares / 1.5598 GBP/$ = GBP 22.2p Cash & Investments per share
$23.4 m Cash & Investments + $336.0 m AUM * 3.75% = $36.0 m / 67.4 m Shares / 1.5598 GBP/$ = GBP 34.2p Intrinsic Value per share
[NB: See prior posts re my 3.75% of AUM valuation of Argo’s asset management business. Also, note I’ve marginally increased total AUM here to reflect impact of EUR/$ on AREO’s AUM since end-June].
At the current GBP 15p share price (and $15.8 m market cap), this implies:
Price / Cash & Investments = 0.67
Price / Intrinsic Value = 0.44
Upside Potential = 128%
It’s also worth mentioning – ARGO’s technicals look promising ahead of the interims. The sudden share price revaluation back in March (to GBP 17.5p) was quickly reversed in April as shareholders took fright re Cyprus – obviously unwarranted, considering Argo’s v minor losses. Since then, the share price has been slowly but surely retracing this decline, with no sign of shareholders anticipating a poor set of results.
Now, let’s tackle the issue I really wanted to highlight – well, I should say the sentence I really wanted to highlight:
‘In the directors’ view these amounts are fully recoverable although they have concluded that it would not be appropriate to continue to recognise income from these investment management services, going forward, as the timing of such receipts may be outside the control of the Company and AREOF.’
This sentence may already be familiar to you as a shareholder – if not, I suggest you read Note. 12 of the 2012 Annual Report right now. Despite the fact it’s a single sentence, buried in the accounting notes, it has significant implications. I understand it to mean AREO management fees will no longer be recorded in Argo’s P&L unless payment’s actually received. And those fees are perhaps larger than you might expect – amounting to 2% of AREO’s original gross placing proceeds (see Note 8. in AREO’s latest annual report), which equates to an annual EUR 2 m (or $2.6 m approx.).
OK, let’s take a breath….
[Of course, we first have to question if this accounting change signals any drastic new development in the relationship between AREO & Argo? For the moment, by default, I’m going to just presume the status quo – as I consider this change long overdue & I suspect the 2012 bad debt provision simply reflected the aging of the AREO receivable. We also have another imponderable to consider – will subsequent payments received from AREO be recorded as revenue, or a reduction in prior receivables? Such questions obviously require a lot more info. from management…]
Now, let me assure you – things are far less grim than they might (suddenly) appear. In fact, the reason I take issue really has nothing to do with revenue or profits (as I will explain). First, let’s consider the financial ramifications. While AREO recorded the full EUR 2 m fee in its accounts, I can’t definitively confirm the full amount was similarly recorded in Argo’s 2012 revenues. I also note ‘AREOF continues to meet part of this obligation to the Argo Group as and when liquidity allows.’ Combing through the accounts, I note the AREO receivable only increased by EUR 50 K, while Argo wrote off EUR 750 K as a bad debt provision – which might imply AREO actually paid EUR 1.2 m of the annual fee. Which, in turn, may imply a prospective reduction of EUR 800 K (or $1.1 m) in annual revenue. [OK, at an extreme, we could possibly see a full $2.6 m sliced off annual revenue].
But really – so what?! Because we already know this…
The deferral of AREO fees has been explicitly noted on a number of occasions, and it’s clearly reflected in Argo’s cashflow statement(s). And from my perspective, it’s already part & parcel of my valuation of Argo’s asset management business. If you recall, I believe my current 3.75% of AUM multiple reflects a substantial haircut (vs. potential business value in different circumstances), to account for this & other risks. It’s also worth noting I don’t include a single dollar of Argo’s total receivables ($4.5 m) in my valuation.
Therefore, considering all facts at this point, I’d argue there should be pretty much a zero incremental impact on Argo’s intrinsic value – despite the prospective decline in revenue & profits. In dollar terms, my current valuation of the asset management business is $12.6 m. That’s a 1.4 Price/Sales ratio, based on 2012 revenue, while prospective revenue might imply a multiple somewhere between 1.6 & 2.0 P/S. None of these are expensive multiples – for any kind of asset management business.
Now I don’t think profits are that relevant to asset management valuations, but let’s also consider the P&L impact. If you take a closer look at the 2012 P&L, I’d argue underlying net income was actually around $2.8 m (exc. bad debt & impairment provisions, plus amortisation) – so it’s reasonable to expect the impact of this accounting change will be easily absorbed under most scenarios. I would note 2012 free cashflow was only $0.2 m – but if we assume a stabilisation in working capital (& the current status quo re AREO), that would elevate underlying free cashflow to around $1.5 m. Also, as mentioned above, increased (non-AREO) management fees & continued expense restraint will hopefully make a contribution in 2013. Of course, results will be ultimately dependent on Argo earning incentive fees again later this year – YTD returns on TAF & ADCF are promising though.
The real issue here is simple:
First, we have what I’d consider another failing in terms of Argo’s investor relations. While I may enjoy nothing better than scouring accounting footnotes, most investors would reasonably expect management to telegraph a potentially substantive change in the P&L far more informatively. And obviously they’d expect that well in advance of results that come out eight mths into the company’s financial year – after all, forewarned is forearmed… The last thing long term shareholders want to see is investors bailing out or avoiding the stock, based on some cursory (& mistaken) assessment of a declining business. Obviously, let’s hope we see management provide some thorough & appropriate analysis, plus commentary, in the upcoming results.
Second, we’re faced with a situation where shareholders have little real idea of the level of profitability, or the prospects, for this AREO management contract – as things stand right now. Nor have they anything like the necessary info. (or clarity) to perform any kind of long/short term cost-benefit analysis regarding this contract. So far, in relation to Argo, I’ve been primarily focused on the potential for enhancing shareholder value & new fund raising, but this is obviously a topic to revisit at a later date. It’s clearly a significant issue for management to address also – again, let’s hope we see some useful guidance in the interims…