I have been busy in the past few weeks, but thought that it would be a useful idea personally to re-run some of my favourite stock screens, in order to ascertain have any potentially new ideas arisen. Along with that, I will be taking a look at Total Produce plc, which is a small European exotic fruit distributor that trades on the Dublin stock exchange.
10 points on UK Retail stocks (or I’m nuts to be still looking at this rubbish)
The news emanating from UK retail stocks simply gets worse and worse. That is unsurprising for anyone that has been following the sector or the UK equity market for any time. However I have come around to thinking that both Mothercare plc & Home Retail Group are materially undervalued. The valuations of both are presently deeply distressed. I have a penchant for being attracted to special situations, and am of the belief that one is emerging on both of these troubled companies. The current state of sales progression and margin collapse may well mean that fixed charge cover falls precipitously low over the next few quarters, if not sooner. However the aforementioned companies have some interesting opportunities that need to be grasped to begin creating shareholder value. There is no reason that either of these companies should go down the route of JJB or HMV. Home Retail already ‘gets’ the direct sales channel, while Mothercare has a very interesting and highly profitable international franchise.
(i) Accelerate the closure of stores in UK and Ireland stores. In my analysis of the Home Retail Group I was shocked to find that in many small and medium sized UK and Irish cities that Argos has stores within 2KM’s of each other. This type of store overlap is deeply foolish I believe. In Dublin for example, Argos has outlets that are 400m apart.
There is significant low hanging fruit in this business that can be eliminated here (but with an exit cost). This is accretive to margins and improves the fixed charge cover. Management need to realise that the UK simply has too much retail space. LFL sales are falling not only because of a poor economy but also due to a shift to direct sales. This trend is not a fad, but is entrenched and will become commonplace. As a retailer, one will need significantly fewer stores. Even if there are exit costs they more than likely should be taken as a hit on the chin. The old ways of ‘if you build it they will come’ store expansion are gone. The will not be returning any time soon.
(ii) The dividend in both companies should be eliminated in order to preserve cashflow and strengthen the balance sheet – I see this as a person who is an unapologetic income investor. A streched balance sheet cannot serve two masters. Once the operating lease committments are capitalised, the balance sheet is dangerously bloated.
(iii) Both companies needs to focus on reducing burgeoning working capital, in particular, inventory days.
(iv) Argos has an unleveraged loan book that is valued at circa £470m and is provisioned to the level of 14%. I think serious consideration must be given to monetizing this loan book (via securitization or outright sale).
(v) Mothercare has made a great deal of reducing UK stores over the next 15 months. What progress is being made on this count?
(vi) Home Retail Group,s Homebase business trades on operating margins that are significantly below that of the peer group. This type of retail outlet is a 5% plus operating margin business at Kingfisher, Travis Perkins and Grafton. Why do Homebases margins lag so materially.
(vii) Home Retail group has cash of £220m and a loan book of £470m that represent almost 90% ofthe market capitalisation of the company.
(viii) Mothercare has a highly successful international franchise operation. It accounts for practically all of the companys profutability. The company is valued at 0.18x revenue. Next and Inditex with similar international franchise operations are valued at 1.2 & 2.2 x revenue.
(ix) 46% of Argos revenue is generated from telephone and internet orders. This company should invest in a delivery service, they simply do not need stores. Other catalogue/direct retailers such as N.Brown and Next trade on 1x revenue.
(x) If you were to do a sum of the parts analysis on Home retail Group, valuing Argos at 0.25x revenue, then you would get the Homebase business for free.
In summary, I am going to purchase shares in both Home Retail and Mothercare, but I am not yet sure when. I expect that the run into the Christmas period will see some pretty poor trading. The balance sheets are weakening by the week. I think that the opportunity actually arieses from how weak the UK retail environment is. A continuation of the present trend will force the fixed charge cover so low that action have to be taken, either by the company or by someone else. The opportunity is that things getting worse will light a fire under the backsides of management teams that I view as being way tooo complacent. These are highly risky speculative stocks. There are many stocks in the UK retail space trading on deeply distressed valuation multiples. I can see how both of these situations have a catalyst that may force change.
My difficulty presently, is that with 20% of my investments now in equities, I am not the keen to push the boat out further at this stage. There is a balance between the valuation attractions of these special situations and my deeply held view that we have not reached valuation or price lows in most of the major global equity indices. Given an 11 year bear market, I think that it is highly likely that compound returns for the average equity will be negative until the market valuation bottoms on single digit Schiller PE’s and P/B’s of at or below 1.
Stock Screen Results
My first screeen is a simple P/B screen. This can be replicated on any free website, such as the FT.com screening tool.
|Stock||P/B||Int Cover||Gearing||RoA (5 yr avg)||RoE ( 5 yr avg)|
The screen is a simple one that ranks stocks by P/B, leverage and returns. I have excluded financials and real estate from the screen. It is an interesting collection of companies. I had hoped to do some work on Kontron by now, but have not found the time. There are two oil refiners which is interesting (OMV and Saras). Given that I will be looking at Total Produce, it is comforting to see that it screens reasonably well. FInally I have excluded lots of stocks that I have already looked at in the constructiona and utility space. From this list, I will be prioritizing work on the refiners, KSB, Kontron and Dart. I have already studied Grafton, and decded that while it does represent good value, that given the outlook it is not great value at this present time.
My second screen is a returns based screen rather than discount to asset valuation. I ammend the standard Greenblat screen to screeen for valuation anomalies when compared with 5yr average RoCE & 10yr avg RoCE. The value being provided by use of EV/EBITDA. As is normal, lossmaking companies and financials are excluded. I also exclude stocks with a market capitalisation below €100m. Why, I simply have never beeen comfortable with micro caps.
This leaves me screening a universe of 950 equities across Europe. In a greenblat screen if I recall he simply invests in the leading 30. I take the top 150 stocks from the screen and then further sort by other valuation metrics and balance sheet strength. (I use P/S, P/B, Gearing, Fixed Charge Cover). This narrows down the field from 150 to 15.
The last screen that I run is a Price/Net Net screen. That is the ratio of market capitalisation to net current assets plus net debt/cash. From this I get 20 stocks across Europe with a P/NNWC of less than 1.
|Company Name||Mkt Cap||Price/Net Net|
|PV Crystalox Solar||39||0.44|
|Gleeson (M J)||67||0.75|
Many of the companies uncovered from this screen are home builders and I have decided that it is Abbey that I am attracted to from the point of view of operating metrics and management track record. However, it is not yet time I feel to take the plunge into UK home-building. Alternative energy companies such as Phoenix Solar and PV Crystrol have beendoing pretty appaulingly. There is a case for looking at the entire alternative energy sector, and includiing the likes of Vestas, Nordex and Gamesa. All have hit hard times recently – but it is worth bearing in mind that all were incredibly highly rated at one stage.
Total Produce – Fruit that is ripe for picking or a basket case?
Total Produce is a small stock that keeps showing up in various different screens that I run for value. Despite working in the financial markets and being based in Ireland, I had noot actually heard of the stock until recently. Given how well it screens, I have decided to do some indepth work on the stock. Despite many defensive food & beverage stocks trading at reasonably high multiples, Total Produce is on an excededingly low level of valuation. Is there an opportunity here, or is it a simple case that there is a valid reason for this?
On all measures using the current share price versus the most recent annual data, the company looks incredibly attractively valued on trailing multiples. Tangible book value is significantly lower than stated book value due to the presence of €140m of goodwill from a total equity of almost €170m. The trailing FCF yield is an incredible 23%. I wonder how sustainable that this is?
Given the underlying returns in the business, I think that this is a stock that quiet justifiably should trade on a significantly higher multiple.
|Gross Profit Growth||22.2%||30.2%||3.1%||1.6%||6.2%|
To my mind this is a business that should trade at the very least at book value. While it is a low margin distribution business, the level of operating cashflow after tax and working capital is quiet staggering.
Cashflow and Other Issues
Since the company was spun out of Ffyfes PLC, it has generated €258m of Net Operating Cashflow, and has spend €84m on capex and €161m on various acquisitions.
Given the cashflow generated in the past two years, one could be forgiven for thinking that the company is underpaying the dividend in a most significant way. In the past four years, Total Produce has paid dividends of €22m to ordinary shareholders, but has paid dividends of €17m to non-controlling shareholders.
In the past year the company has spent just under €9m on a shrebuyback of 22m shares (6.25% of the sharecount). I have always detested sharebuybacks. It presupposes that management know how to time the trading of the shares in their own company – there is no evidence that this is the case.
My principal dislike of buybacks is that they achieve very little, other than a temporary boost in the share price. In most case the purchasing company does not cancel the shares. Alas, Total Produce has fallen into this trap. All of the shares purchased are held as treasury shares to be reissued at another date. What is the benefit to shareholders of this. In my years in the markets, it has never been satisfactorily explained to me. If a company wishes to return funds to shareholders, then a dividend or special dividend is the way to go about doing this. For a company with such cash generating characteristics there is no reason for this. Acquisitions can be funded through cash generation.
If I were to use a no-growth DCF in order to value the company, as follows:
|EV of FCF||313037.5||278255.6||250430||208691.7||178878.6||156518.8|
I take the last years FCF and discount into perpetuity assuming no growth, using various cost of equities. It is not perfect, in that most DCF’s are GIGO. However it does offer some semblance of a sanity check. To put it another way, the present share price & FCF is implying almost a 12% cost of equity if one assumes no further growth. What this tells me is that from a fundamental valuation point of view, is that if cashflow is sustainable (but only that), then it is only at very high cost of equities that there is fundamental downside. Equity risk premia are high at the present, but in my opinion are likely to stay that way until the secular bear market/recession/deleveraging are behind us.
I have rarely encountered a company that is capable of generating such significant amounts of free cashflow. I am immediately suspicious. The company generates between 4% & 5% of assets as FCF, and a staggering 17%+ of equity as FCF. If I was to ever own a company, I would like to own a company that year in year out genreated those types of cash returns.
The key for such a cash generator is:
(1) How does it achieve this?
To simplify the analysis, I look at the cashflow statement from a % of revenue stance. In the past 5 years, the company has on average, produced a cashflow statement with the characteristics laid out below.
Total Produce – Average Cashflow (%of sales method)
|FV Movement on Inv Prop||0.00%|
|Other Non Cash adjustments||-0.02%|
|Income Tax Paid||-0.48%|
|Net Interest Expense||-0.16%|
|Dividend to Minority Shareholders||-0.20%|
|Working Capital Movements||0.33%|
|Net Cashflow from Operations||1.98%|
Working capital is not a significant cash consumer as (i) inventory days average 7.5 days which is to be expected given that the product is fresh fruit. Debtor days average apporximately 45days with creditor days coming in at approximately 55 days. Hence, since the spin off from Fyffes, the company has seen a net cash inflow due to working capital management. The key drivers of cashflow then are operating margins and capex in any one year.
(2) How sustainable is it?
Given that this is a low margin business, there is very little room for manoeuvre if costs rise. In this regard it is worth noting that cost of goods sold has been relatively stable at just over 86% for the past 6 years. Operating expenditure has risen from 11.4% to 12.3% of revenue in the same time period. I would be interested to know why this is the case? Having taken a peak at Chiquita and Fresh Del Monte, it would seem that all business operate with very low operating margins. However in the past 5 years these been reasonably stable. My worry would be that small increases in the cost of goods sold can have a dramatic impact on underlying profitabilty. This is something I would like to get to the bottom of as it is the key determinant of cashflow sustainability.
(3) How will it use the cashflow?
Capital expenditure to sales has fallen in the past 6 years. In the last fiscal year capex came in at 50bps of revenue from 1.6% in 2006. However capex at Chiquita averages 1.9% and is approximately 2.4% at Fesh Del Monte. Why is this? How can Total Produce get away with having significantly less paex outlay than two large competitors in the fresh fruit distribution business. Again, I have no real answers for this
The industry is a consolidating one. Given the strength of cashflow and balance sheet it is to be expected that Total produce will look to play a part in consolidation. There are numerous in country players that the larger international players will seek to aquire in the future. In the past the company has made acquisitions in the UK, Scandinavia, India and South Africa.
Corporate Governance Issues
There are obvious areas where this company falls down in terms of corporate givernance. For example, the four person management team at Total Produce earned €2.7million in 2010. The leading Irish fodd company is arguably Kerry Group plc. They operate globally where they are a leader in the international flavours and ingredients business. They are many times larger than Total Produce and have sustained strong returns for decades. The four person management team there are paid €5.2m. Total Produce management remuneration accounts for 7.2% of operating profit, versus 1% at Kerry Group? Why is this?
For the past number of years, Total Produce, a fruit distribution business has taken impairment charges & fair value adjustments taken against an investment property portfolio. It seems as if these relate to investments in a company related to the chairman of Total Produce. Total Produce is also involved in some JV’s with a property company with close links to the chairman. There are reported in related party transactions. Furthermore, the company has sold some agriculatural land in South Africa to a business partner there, but has in turn increased its shareholding in that business partner. I really dont like to see this. It seems to me as ith there is a lot of corporate musical chairs going on here.
Total Procuce is presently producing a level of cashflow that is in my opinion materially undervalued by the market. It has some of the attractions that I am seeeking. The company would seem to have strong posiitions in many of the markets that it is present, and has some oportunities in India, South Africa and China.
There are hurdles to investing, chiefly:
(i) very low margins and capex that is materially lower than peers,
(ii) some corporate governance worries,
(iii) timing of acquisitions
(iv) what liklihood in a spike in cost of goods sold?
(v) The question that I would really like answered is the following. Given the low leverage and high level of seemingly recurring cashflow together with strong market positions, I would have thought that private equity would be all over this type of investment. But that does not seem the case – why is that?