Its Started

I have taken advantage of the recent turmoil to begin investing once again. Investing as opposed to trading that is (not that I have anything against trading).

I have allocated 5% of my available capital into CRH PLC, a global cement and aggregates player HQ in Ireland and trading on the Dublin and London stock exchanges. I am wary of catching falling knives, and that has influenced my opinions at this time. So for now, I will continue to work on Home Retail, Barclays, Unicredit, et al but am not ready to invest there yet (if at all). There are several cement & aggregates companies in Europe that trade on lower multiples than CRH, however they do not have the long term operating performance that CRH has achieved.
My all in entry price is €12.05, which produces a gross dividend yield of 5.2%. My net dividend will more than likely have a greater yield than my deposits, but with added price volatility – which I can handle. Now with interim results due shortly this may appear foolish to some, but I have never been overduely influenced by one set of results, particularly interims.

I should caveat, that I am still in the bear camp on markets, but I think that this will be the beginning of the end of the bear market. That does not mean that it will end tomorrow or next week, but more probably in the next few years. Patience and opportunism is required in present market conditions.

What attracted me to CRH, other than valuation, is that margins have come back from to levels that are significantly lower than they have been at any time since 1994. During 2010 the company reported an Operating Margin of 4.1% and a Pretax Profit Margin of 3.1%. The average EBIT and Pretax margin since 1995 have been 8.4% and 7.4% respectively. A 2% point fall in gross margins have driven a near halving of operating margins. Admittedly over the 16 years of profitability data that I have, there have not been the types of global economic challenges that society presently face. I remain in the camp that valuation and not economic growth drives future returns. Sales have declined over the past three years.

This is a business that has a decent balance sheet (albeit, it was more decent a few years back). Net Debt/EBITDA of 1.8x is at the upper end if where it has been over the past decade, yet the company has an Interest Cover of 6.5x. In gearing terms, that is a Debt/Equity ratio of 28.4%. Both the Debt ratio and Interest Cover are well below the minimums in the loan covenants.

Cashflow can be variable but over the past decade the business has often produced operating cashflow between €1 and €1.4 billion. Anytime it is greater than that is due to gains in working capital release, which I would not usually bet on.

Despite reduced margins CRH has produced almost €1bn of FCF on my calculations, leaving the company trading on an 11% FCF yield. P/S at 49% is significantly below where it has traded in the past. I am calculating a Graham & Dodd PE of 8, which is almost a 33% discount to the MSCI Europe. As an aside, a Graham & Dodd PE of 12 for the MSCI Europe is close to where prrior bear market lows have kicked in.

The way I see it, I am buying operational leverage and optionality on an improvement in future profitability. I am doing that on valuations that are, for me very attractive. This company generates cash year in year out. On a net operating cash basis, CRH has managed a ROA average of 10% hstorically versus 6.5% presently. Straight ROE of 13% historically versus 5% presently. P/B of 0.83 and a yield of 5.2% that is more than twice covered by free cashflow.

I have no idea as to when revenue or margins will recover, however if the company were to return to normalised profit margins the company would at the present share price trade at a PE of under 8x, and yield almost 16% in terms of FCF. This is too appealing an opportunity. I have a feeling given how markets are behaving that the price that I purchased will more than likely not represent the low in the stock, but I feel that this is too much of an opportunity for me to ignore.

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John McElligott

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