Thursday, 28 February 2013

Go West Young Man!

And N Brown Group PLC

British businessmen are attracted by America's size, wealth and deceptively easy access for English speakers with the same unrestrained enthusiasm that the Spanish conquistador was attracted to the legendary El Dorado. And like the conquistadors, for every adventurer that struck gold, there are many more who have perished in the attempt.

The pharmaceutical companies Glaxo and Astra Zeneca, the defence contractor BAE Systems and the technology concern Smiths Group have all been spectacularly successful in America. They are among the few.

Ferranti, an electronics business and constituent of the FTSE 100, was brought low in 1993 following its takeover of the US defence contractor International Signal and Control (ISC). It turned out that ISC had been making its only profits from the illicit sale of missiles to South Africa, Iraq and Chile. The 15-year prison sentence handed down to ISC's CEO did little good  for Ferranti's empty-handed shareholders.

Midland Bank, one of the "Big Four" clearers, was forced into the hands of HSBC 5 years after acquiring Crocker National Bank of California in 1981. Billion pound losses on Latin American loans overwhelmed Crocker and severely weakened its parent, Midland.

RBS's demise was also Made in America. Fred Goodwin boasted that, after acquiring ABN Amro's US operations, he had the sixth largest bank in America. So he did, and it sunk the ship with perhaps 20 billion in losses on subprime mortgages.

HSBC, failing to learn from Midland's US experience, bought Household Finance Corporation in 2002. Household was the second largest subprime lender in the US. HSBC stopped its trading in 2009 while providing $16.3 billion in bad loans and a $10.6 billion write-down on its purchase. HSBC immediately followed this with an $18 billion rights issue, which saved the bank.

The walking wounded include many British companies in the retail sector (thanks to Sarah Butler, The Guardian, 5.12.12 for this list):

HMV extracted itself from the US in 2004 after failing to make a profit from expensive and over-ambitious stores.

WH Smith sold its US airport and hotel stores after the retail meltdown that followed the 9/11 terrorist attacks in 2001.

J Sainsbury sold its upmarket grocery chain Shaw's in 2004 after failing to expand the business sufficiently to take on the US's biggest grocery chains.

Marks & Spencer lost two-thirds of its investment when it sold the fashion chain Brooks Brothers in 2001. It sold its upmarket grocery chain King's in 2006, deciding it did not want to invest enough to expand.

Dixons sold its stake in the US electricals chain Silo in 1993, six years after acquiring it, after losses caused by over-expansion during a recession.

Laura Ashley sold its US chain for a dollar in 1999 after over-ambitious expansion led to a string of profit warnings.

At Body Shop, heavy losses at its US operations in the late 1990s forced it to close its manufacturing operations there.

Now it's the turn of Tesco. Its Fresh & Easy stores have cost the company a billion pounds or so as well as top management time. Tesco's new CEO has put them up for sale.

British managers too often underestimate the strength of their competitors in America. Entrenched American companies have many advantages over their new UK competitors. Not only are they are larger and know the market, but they also benefit from customer loyalty and the best technology. And they have access to cheap financing.

British companies must have something that is very special to succeed in the most competitive market in the world. In the case of Glaxo and Astra Zeneca they had patented drugs, in the case of BAE and Smiths Group, patented technology. And these companies became part American and so behave like Americans. Glaxo has four American board members, Astra Zeneca three, BAE five and Smiths Group one. Shell (with 2 American board members), BP (with 5) and Unilever (with 3) all have big operations in the USA. Tesco, in contrast, has one American on the 15-member Board of Directors, and she was appointed in March 2012 (before that there were none). The CEO of Fresh & Easy is a Brit.

Retailers, by comparison, have little to offer the American consumer. Spain's Inditex, the world's largest fashion retailer, has more stores in the UAE than in the USA - and it has chosen to spearhead its American entry via the internet. Sweden's H & M, the world's second largest fashion retailer, is also moving from stores to the internet in the US. Next, Britain's largest fashion retailer, hasn't a single American store, but you can buy its products online there. It's the cheap way in.

When the savvy investor learns that one of his companies is launching a new business or, even worse, trumpets buying a 'transformational' business in America, he should immediately consider selling his shareholding.  To keep his share, he will have to satisfy himself that:
1. The Chairman is not on an ego trip.
2. The Company has something unique to offer the American consumer and it has spelt out how much it will invest. Open ended commitments often end in tears.
3. The Company should have already tested the market via a distributor, agent or online. Tesco tested its concept for 2 years prior to opening its first store, and still it failed.
4. The Company hires a top rate American team to run its operations and appoints its American CEO to the Board.
5. The Company can comfortably afford the potential loss from its American venture.


N Brown Group PLC

N Brown has established itself as the market leader in outsized clothes bought by middle-aged women on-line and by direct mail in the UK. The company has been consistently profitable. It went through a slow patch in the early Noughties as it adopted TV marketing, which was soon abandoned in favour of online selling. N Brown now sources 54% of its sales online, up from 28% in 2008. This is good for the business: it is cheaper to service than other marketing outlets and the order value per customer is 25% higher. The company has ventured into the high street with its Simply Be brand. Initial results are 'promising', but the stores are loss-making. A review is promised for March this year.

N Brown shareholders have enjoyed an annualised return of about 11.7% since 1988, compared to 6.6% on the FTSE 250. But N Brown shares (in blue) are much more volatile than the FTSE 250 Index (in red). (Source: Yahoo - click on the graph to enlarge)

N Brown has been a strictly British concern, with a German operation launched in 2009. In 2010 its CEO announced a trial in America describing the US as "a major market with everything you need for a home shopping business – the infrastructure is there." American orders would be serviced from N Brown's UK base, keeping the cost of the US launch below £1m.

How has the American venture prospered?

In the 2012 Annual Report, the company highlights: Simply Be is doing us proud in America
too. Our US business model remains promising with good margins and 74,000 new customers
joined us last year. The only results provided for the USA include Germany: 

USA and Germany
Loss as % of revenue
8.4 million
4.2 million
4.8 million
2.3 million

It must be a concern that the higher the revenues, the higher are the losses.

In the latest Interim Report (October 2012), the CEO comments:

"Sales in the USA increased by 53% to £3.4m. The US customer is in general more casual and conservative than their UK counterpart and we have tested Marisota as an alternative brand for direct mail campaigns with some success, leaving Simply Be to be promoted primarily in the online channel. We anticipate further progress in the second half and a reduced level of losses." No figure for the losses appears in the report.  

Though we have not been provided with the losses for the American venture, we can be sure that they exceed the original 1 million pounds that were expected in 2010. A new CEO, Ms Angela Spindler, has been appointed. The loss of the reigning CEO coincides with the resignation of the Chairman, Lord Alliance, who was founder of the present business and owner, together with his brother, of 44% of the outstanding shares. N Brown has no American director. 

N Brown is cash generating, with its operating cash more than sufficient to pay both the dividend (it yields 3.3%) and the company's modest capital expenditure requirements. Net debt is a comfortable 45% of net equity. Like many companies that regularly generate an excess of cash, N Brown is a serial buyer of businesses.  

The average return on equity of all its new investments is about 15%, well below its average ROE of 21%. Or, to put it another way, its core business is more profitable than the rest. Some - such as branching into men's clothing, use the company's well-honed skills. Completely new ventures, such as Germany and the US and the new stores, are currently a burden. But the dynamics of the home shopping business mean that it takes years to get it right and get it profitable. The same applies to stores. Angela Spindler has been chosen for her background in stores (Debenhams, The Original Factory Group, George and others). 

The valuation model gives an intrinsic value of 361p a share to N Brown. It is currently trading at 397p See below for assumptions. 

5 year earnings
5 year return on equity
5 year equity per share
The cautious investor will want to consider: 

1. The possible damage to earnings of the company's ventures abroad and into stores. 

2. Whether the new CEO represents an opportunity to improve the business, or whether she will be tempted to push what she knows best - stores - at the expense of what N Brown does best - home shopping.

Earnings per share growth of 6% pa.
Equity per share growth of 9% pa.
Return on equity of 15%
Discount rate of 11.3% based on:
                                             Weighted cost of debt of 4.3%
                                             Risk premium of 2%
                                             Profit and margin of safety of 5%
Average PE ratio of 15.5. Current PE Ratio 13.5.









Wednesday, 20 February 2013

Warren Buffett

And is Berkshire Hathaway Good Value?

Warren Buffett in 2005 (Wikipedia)

There is something very comforting about Mr Buffett. Unlike that geek Bill Gates or that wunderkind showman, the late Steve Jobs, Warren Buffett seems like one of us. He is reputed to work from his study at the home he bought in 1958 and to drive an old car. He lives in one of those vast, empty states in America - Nebraska - where nothing ever happens, and he is addicted to one of those fizzy, sugary American drinks, Cherry Coke. We can imagine him flipping burgers at the barbecue and playing bridge with his chums.

But, as an investor, Mr Buffett is nothing like us. Son of a stockbroker, he was a child prodigy investor and businessman. He studied finance at Wharton and Columbia and worked with Benjamin Graham on Wall Street. He is adept at using other people's money. At first the money came from his partners - he provided the sweat and brains. Then, as CEO of Berkshire Hathaway, he ventured into insurance because customers paid up in advance, sometimes years in advance of their claims, and meanwhile he had use of their funds for free. With the enormous funds at his disposal and a reputation for integrity, he can make investments that we can only dream about.

What can we learn as investors from Mr Buffett? In his public statements, company reports and annual letters to Berkshire shareholders (available online at the company's website) he offers us his homespun philosophy. It is couched in language as distant from the financial gobbledegook of academics and financiers as Omaha is from Wall Street. But it makes sense.
ü  Invest only in what you understand.
ü  Ignore the ups and downs of the stock market.

ü  When everyone is predicting doom and stocks are crashing at a stomach-churning rate, this is the best moment to buy.

ü  When everyone is saying this is the moment to buy and the stock market is in a state of euphoria, this is the worst moment to buy and the best time to sell.

ü  Instead of hiding from your mistakes, study them carefully so you don't repeat them.

ü  Buy for the long term, and as if you are about to own the whole company.
Mr Buffett once said, "I'm 15 percent Fisher and 85 percent Benjamin Graham." Phillip Fisher is the author of Common Stocks and Uncommon Profits, while Graham is the author of The Intelligent Investor and, with Dodd, Security Analysis. From Buffettology and other books written by third parties on how he (supposedly) works, and from reading Fisher and Graham, one can get an idea of his method.
Although everyone must come to his or her own conclusions, I would start by asking these questions of any company (from Buffettology by Mary Buffett).
  1. Do you understand the business?
  2. Is it a commodity business or is it not? Does it have a ‘toll bridge’ or some class of monopoly? This is related to ease of entry and the competitive position of the company.
  3. Does it have strong earnings that you can forecast with a degree of certainty?
  4. Is it conservatively financed?
  5. Does it have a high return on equity?
  6. Does it retain earnings?
  7. Does it have low maintenance – i.e. low capital expenditure and R & D?
  8. Does it have a good record of reinvesting cash that it generates – via share buybacks, new ventures, acquisitions or expanding the business?
  9. Can it adjust prices to inflation? 

Once a company has been identified as a suitable investment, what is its intrinsic value, and what should one pay for a share? Finding the intrinsic value of a company is searching for the Holy Grail, but there are techniques that can help. They will depend on the nature of the business, but if it is a trading company one can use a simple mathematical model that is centred on equity per share, earnings per share and return on equity. As the quality of forecasts drops dramatically as time proceeds, it seems wise to limit the necessary forecasting to 5 or at most 10 years. What will the company's share be worth then? 

Benjamin Graham banged home the concept of a margin of safety. For every investment he made an evaluation of its intrinsic value and then allowed a margin of safety. Buffett does the same. 

A margin of safety can be incorporated into the discount rate applied to the future value of the share. The discount rate includes the cost of debt to the company plus a profit plus the risk, or margin of safety. Discounting back the future value of the share gives an approximate intrinsic value. We do not buy a share in the company unless its market price is below our calculated intrinsic value.

Warren Buffett has pledged nearly his entire fortune to charity.


Is Berkshire Hathaway Good Value?

Berkshire Hathaway is a conglomerate of businesses thrown together by two gentlemen who are now in their eighties. It very obviously has a succession 'challenge'. No one can replace Warren Buffett (and his partner Charlie Munger). He is the patrician, the eminence gris, the company personified, the master investor and he controls 34% of Berkshire's voting rights. As open as ever, he discusses his succession plans at some depth in Berkshire's 2011 Annual Report (p. 97).  

Buffett has gathered, motivated and rewarded an extraordinarily talented group of people, who manage Berkshire's seventy plus concerns. This is, perhaps, his greatest contribution to the company, and one has to wonder what will happen to them when he retires (or dies in office). Will they all be happy with the new chief? Will the new chief be able to keep them and motivate them? Or will there be a stream of desertions, as they are lured away by companies that can offer them the prize of running their own concern, without interference from above? 

A significant part of Berkshire's growth has come via acquisitions. Owners trust Buffett to keep their companies for ever in the Berkshire family. This means that Buffett will hold on to underperforming businesses indefinitely, but in exchange he gets first pick of the businesses for sale. Will a new CEO be as patient? Or will he (the candidates are all men) reorganise the empire by disposing of these underperforming assets? 

The following graph (Thompson-Reuters - click it to enlarge) is the embodiment of the Buffett legend. Berkshire (blue) has vastly outperformed the S&P 500 (red) since 1990, though the S & P 500 excludes reinvested dividends - and Berkshire doesn't pay dividends.

Putting aside the succession issue, is Berkshire good value now? 

The past 5 turbulent years have not been a happy time for Berkshire shareholders. They have seen their stock appreciate by 8% while the S & P 500 has increased by 14% or by about 30% with dividends reinvested. (Thompson-Reuters - click on the graph to enlarge it)


What has happened? Berkshire's book value has increased by a healthy 58% during this period, comfortably outperforming the S & P 500. In part this is because the company’s 'Equity Investments' have almost tripled to $76 billion. But earnings per share have declined by 28%. This is due entirely to a swing on 'Investments and Derivatives' that, by their nature, are highly volatile. Return on equity has averaged 8% over this period. These are far from stellar results. The size of the company - net equity is $165 billion - seems to be a drag on growth. At the current price of $ 152,000 per 'A' share, the company is valued at 19.4 times estimated 2012 earnings. Is Berkshire just going through a relatively bad period?
The recently announced Heinz investment will improve earnings per share; Berkshire will net $1.08 billion pre-tax from the preference shares and half Heinz's after tax earnings. The funding comes from Berkshire's float that costs nothing. The deal will enhance earnings by at least 10%.
Berkshire's unsecured debt is rated AA by S&P. Cash and liquid investments are more than double the company's outstanding debt.
Taking the period 2002-2012, and averaging three year periods at the beginning and end (and removing non-operating profits and losses), earnings per share are growing by 15% pa. Equity per share is growing by 12%. Return on equity has averaged 8%. AA 12-year corporate bonds are yielding 3.9% and I have added 2% for operating risk and 5% for a profit and margin of safety to arrive at a discount rate of 10.9%.
This gives an average valuation of $165,000 per 'A' share:

Valuation based on:
$ value per 'A' share
5-year earnings per share growth to 2017
5-year equity per share growth to 2017
5-year return on equity to 2017
              Current share price

At the current price of $152,000, Berkshire appears to be good value.
The prudent investor will consider:
1. Will Berkshire's success continue under someone new?
2. Buffett thinks that the insurance float's growth is likely to tail off. No doubt this is because as the insurance business matures, its premium growth will slow and its payouts on claims will increase. Given that it is this float that finances Berkshire's investments for free, this will have a knock-on effect on earnings.
3. How long can such a large company find good deals that will make a material difference to earnings? Where will the growth come from?


Wednesday, 13 February 2013

Finding Value in AIM

And James Halstead PLC

AIM (formerly the Alternative Investment Market) was founded in 1995 to allow investors access to young companies that could not qualify or would not pay the cost for a listing on the main market of the London Stock Exchange (LSE). Or was it founded to allow companies, which could not qualify or would not pay the cost for a listing on the main market, access to the pockets of Joe Public, thereby giving more jobs to the boys in the City?
According to the LSE, "AIM is the most successful growth market in the world." At the last count there were 1,096 companies listed on AIM compared to a peak of 1,399 seven years ago. Companies have raised 80 billion pounds. Yes, it's been a wonderful source of fees and commissions for brokers, accountants, lawyers and market makers, for all those who count at the LSE. But what about the humble investor?
Looking at the results of the AIM Index (blue) compared to the FTSE 100 (green) for the past 12 years, shows just how rotten AIM shares have been for the investor:

Graph from Yahoo - click on the graph to enlarge.
Yet there are pearls in the midst of all that dung. And AIM shares have one feature that marks them out from the main list: given certain requirements, if funds are held for a minimum of 2 years in AIM stocks, they are exempt from Inheritance Tax on Judgement Day. This tax feature has attracted good family-run businesses that can pass on their shares to the next generation without the 40% tax burden. It is here that one finds the pearls.
As the tax concession is an important incentive to investing in AIM shares, it is important to know what companies will qualify as "business relief" for Inheritance Tax.
1. The company may not also be quoted on a "recognized overseas exchange" (HMRC).
2. The company may not be engaged "wholly or mainly in dealing in securities, stocks or shares, land or buildings, or in making or holding investments" (HMRC).
3. If the company is acquired (or you decide to sell it) before the 2 years are up, provided you reinvest in another AIM company that complies with 1 and 2 above and together they are held for at least 2 years, the funds will be free of Inheritance Tax.
There are other considerations that are peculiar to investing in AIM companies.

As they are usually small cap, the touch - the bid to offer spread - can be very high. Invest in Venn Life Sciences (market capitalization of 7 million pounds), and the stock must appreciate by 18% before you break even. For Verdes Management, who specialise in corporate restructuring, that's 67%.

Mkt. Capitalization
Verdes Management
0.6 million pounds
Venn Life Sciences
7 million pounds
FW Thorpe
120 million pounds
Severn Trent
Main market
3.8 billion pounds

A second consideration is that, unlike the main market, AIM’s listing rules do not require companies to have a minimum free float. "Free float" is the proportion of shares that are freely traded in the market compared to the number held by all parties. Free float is important because companies can be taken private by their owners at the price they choose if they control 75% of outstanding shares.
Camkids Group, a Chinese sportswear manufacturer, came to AIM six weeks ago with a free float of just 8% of its shares. Mr. Zhang Congming owns 66.3% of the company. This leaves the ordinary shareholder defenseless. Camkids could go private tomorrow, leaving shareholders with paper in an unquoted company based in Fujian province. .All AIM companies are obliged to inform the public of their free float on their websites.
A third consideration is that AIM stocks can easily run out of money. Last week's Investors Chronicle reckons 46 junior mining companies on AIM are "up to their necks in financial quicksand". Small and high risk companies often find it impossible to get bank financing and they do not have the option of issuing debt instruments. If in need, they must dilute shareholders via a public offering or shut up shop.
The wise investor will approach an AIM-quoted company with the circumspection a bear approaches  a honey trap:
1. Stick to companies with no debt, a profitable trading record in a niche market and that are cash generative.
2. Be sure management can be trusted to do the best for the company and not just look after themselves.
3. Check whether the company is quoted on an overseas market and is eligible for Inheritance Tax business relief.
4. Ensure that the free float is well in excess of 25%; look for well regarded institutional investors who are invested in the company.
5. Take into consideration the share price's bid to offer spread.
6. Have a clear exit strategy. You might need it.


James Halstead PLC

It says something for British enterprise that one of the darlings of AIM is a company specialising in commercial, office and industrial flooring. Halstead is the largest company of its kind and the only one which manufactures these floors in the UK. With a market capitalisation of over 600 million pounds, it is one of the 20 largest companies listed on AIM.
The company is managed by the Halstead family (Geoffrey is Chairman and his son Mark is CEO). Two-thirds of sales are abroad, largely in Germany, Scandinavia and Australia, though it has significant businesses in many more.
James Halstead is very profitable - net margins are 18% of sales and average return on equity is a healthy 28%. Earnings per share have increased by a compound 12% p.a. since 2001, and continue to grow despite the slowdown in its major markets.
Halstead consistently generates more cash than it can use. The company buys back shares and pays special dividends, and it still it has 39 million pounds in net cash, equivalent to 6% of its market value. In 2012 the company returned almost 7% of its current market price of 300p in dividends and share buybacks and net cash still increased by nearly 5 million pounds. Capital demands, for plant and warehouses, are relatively light.
Although Halstead closed its defined benefit pension scheme to new members in 2000, its gross pension assets are 35% of all assets and its gross pension liabilities are 90% of all liabilities. As the company's market value is over 11 times the pension scheme's gross liabilities and 60 times its deficit, this is not a serious concern. However, with the application this year of IAS19 amendments (see 30 January post), expect Halstead to take a charge to its balance sheet.
James Halstead is well-managed by a family who see themselves as custodians of the business, in which they have a stake of 34%. And another director has an interest of a further 6%. Despite the construction recession in many developed markets, the company should continue to do well. It is not surprising that the company is highly rated and is currently trading on a PE ratio of 21. The shares yield 2.7%. The company is eligible for Inheritance Tax business relief. But is it good value at 300p a share?
My valuation model gives a value of 242p a share, considerably below the present offer price of 300p. Its shares trade on a bid to offer spread of 7%, 6 times the spread of a similarly capitalised stock on the main list (Diploma Group).  The company has traded between 231p (2 March 2012) and 355p (11 January 2013) in the last year.
The patient investor will note that:
1. The present price of the stock places a valuation on the company that cannot be easily justified, unless he is urgently building a portfolio of AIM stocks for their special IHT exempt status.
2.  Consistently high margins and steady growth in an industry that does not have that many barriers to entry could attract greater competition and a shrinking of margins.
3.  While there is always the risk that AIM listed companies move to the main market, thereby nullifying their special Inheritance Tax status, this seems unlikely for James Halstead. The Halsteads are the first shareholders to want to keep this tax concession going.

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