Archive Page 2

Are Eurozone Equities good value? Part 1

In many of my posts thus far, I have commented that the European equity indices are becoming more attractive in terms of long-term valuation – specifically in terms of P/B and Graham & Dodd PE. In spite of this apparent value, I am not anyway near fully invested with my own funds. The reasons for this are simple:

(i) I am of the view that we remain in a secular bear market for equities that began in 2000. In secular bear markets, equities typically spend at least a decade if not 15+ years de-rating until the valuation is low enough.

(ii) On the basis of prior valuation lows, I am not sure that we are there yet in terms of overall market valuation. Getting there, but not there.

(iii) I have had a suspicion that the reason European indices look so attractive from a valuation stance is that financial equities still make up a large proportion of many European regional/country indices. If much of the valuation of European equity indices is being driven by a combination of the weigting of banks in the index and exceptionally low valuations for banks, then it might just be the case the a valuation argument for European equities in general is illusory.

The purpose of this post is to ask, do European equities represent good value? The first post will concentrate on Austria, Belgium, Ireland, the Netherlands and Portugal. The second post will look at the major equity indices in Germany, France, Spain and Italy. Greece is not represented, simply as I do not want to take the currency risk that I feel is coming their way. There will be a time to look at Greece.

As it stands today, the P/B for MSCI Europe is 1.3x and the Schiller PE is 12x.

Source: Morgan Stanley, European Equity Strategy, 28 Nov 2011. Secker, Carr, Garman & Lim.

It would appear that we are at or below average valuations for Europe. The P/S graph reproduced from the Morgan Stanley strategy report is interesting. It specifically excludes financial stocks, revealing that MSCI Europe is trading at its long run average multiple. The Schiller PE is below average and includes financial equities. This supports my assertion that when the stocks of Banks and Insurance companies are excluded, that the average European equity is not compelling in terms of valuation.

Country Analysis


Graham & Dodd PE: 12x

Price/Book: 0.8x

(This portion of the post has been edited. An eagle-eyed reader has pointed out to me that some of the valuation data for some previously mentioned Austrian stocks was incorrect. Having checked this I have found that the feed for market capitalisation that I used only accounted for the protion of the market cap in the index, which differed materially from the actual market cap. Apologies for this).

Of the seven stocks with single digit PE10 ratios, there are two banks (Erste & Raiffeisen), two are construction stocks (Strabag & Wienerberger), the remainder are utilities and energy companies. MOV maybe worth a look at. But I am not that interested in adding Austrian banks to my research list presently. Other than these stocks, which also appear on the low P/B list – the other low P/B stocks in Austria are predominantly real estate vehicles.


Graham & Dodd PE: 13.2x

Price/Book: 0.99x

Stocks with lower PE10 ratios than the market include:

Dexia 0.4
KBC 2.9
Solvay 8.1
Belgacom 10.0
Mobistar 10.3
Ackermans Van Haren 11.9
Bekaert 11.9
GBL 12.5
Delhaize 12.8

 Two of these stocks are financial holding companies, two are banks, two are telecom operators.

In terms of P/B multiples, we get the following picture,

Dexia 0.08
KBC 0.18
Ageas 0.40
GBL 0.54
GDF Suez 0.71
Cofinimmo 0.81
Solvay 0.81
Befimmo 0.81
Delhaize 0.88
Bekaert 0.99

Three stocks here catch my eye, namely Delhaize, Solvay and GBL (Groupe Bruxelles Lambert). It would appear that Solvay and GBL have large net cash positions and are trading on low book and earning multiples.


Graham & Dodd PE: 15.2x

Price/Book: 1.2X

The Irish market was one of the strongest performers in Europe during 2011, recording a 0.6% decline on the year. Not bad considering that many markets fell over 10% during 2011.

I terms of what stands out is that Ryanair, Kerry Group. ARYTZA and Paddy Power all trade on a PE10 of greater than 20x. Hardly appealing in terms of valuation. Many of the companies have grown successfully over the past decade. This growth in revenue and earnings is naturally reflected in a higher rating. Much of this is deserved, but how much I don’t know.

CRH is valued at 1.1x P/B and a PE10 of 13.2. Significantly more appealing in terms of valuation.

The real bargains in the Irish market are to be found in financials, where Bank of Ireland is presently trading on a P/B of 0.31 and a PE10 of 4.3. The leading Irish non-life insurer, FBD Holdings is trading on a P/B of 1.2 and a PE10 0f 3x.

Elsewhere , Grafton Group, Independent News and Media, Total Produce and Abbey all trade on single digit Graham and Dodd PE’s.


Graham & Dodd PE: 13.2x

Price/Book: 1.39x

Once again the low PE10 ratio stocks are dominated by financials (Aegon, ING Group and Corio).

Aegon 3.8
ING Group 5.1
ArcelorMittal 8.7
KPN 9.1
Corio 9.8
Philips 9.9
Wolters Kluwer 10.4

At the other end of the valuation spectrum there is Heineken NV (23x), Fugro (24x), Unilever NV (31x) and ASML (48x). All in all, there are some fine companies in the main Dutch index, but there is nothing that I am particularly attracted to.


The Lisbon Index finished 2011 down 19%.

Graham & Dodd PE: 16x

Price/Book: 1.03x

The high PE10 for the Portuguese market is down to the high weighting and high valuation of retailer, Jeronimo Martins in the index (PE10 = 65).

What is immediately striking about the Portuguese market for me, is that other than the banks, many of the non-financial equities are very highly leveraged.

Company P/B Gearing ROE G&D PE
BCP 0.14 1439% 7% 2.11
BPI 0.55 5051% 24% 2.31
REN 0.52 237% 11% 2.81
Banif Financial 0.19 1687% 4% 4.24
Semapa 0.64 108% 14% 4.44
BES 0.29 1334% 6% 4.85
Mota Egil 0.54 287% 10% 5.49
Sonae 0.70 218% 11% 6.28
EDP   1.11 214% 18% 6.34
Brisa 0.94 142% 14% 6.65

Of the 10 stocks with single digit Graham & Dodd PE’s, 4 are banks (BCP, BES, BPI, Banif). REN and EDP are utilities, (as is BRISA for that matter). Given the low through the cycle RoE combined with high amounts of leverage, there is nothing that stands out to me as being particularly appealing.


In terms of secondary equity markets in Europe, only Austria as an index offers highly attractive valuations across the board. The other indices are trading close to or at a premium to the MSCI Europe average. This post, is not however about trying to ascertain what is cheap relative to a particular index. Instead, its purpose is to lift the lid of the index, and find out what is driving the valuation. In remain with the impression that it is largely financials, telecoms/utilities and construction stocks that are responsible for the low valuation present in European equity indices.

There is nothing necessarily wrong with that. Many value investors will choose to simply follow the value. In this regard however, it is worth recalling that financials typically trade at a discount to the overall market due to wafer thin profit margins and the highly leveraged nature of the business. This is not a recent phenomenon, but a historical one. The question for investors in financials to answer is that has the level of discounting been overdone and what are the risks to the business case going forward.

In terms of other areas, the amount of construction stocks appearing is a constant. I accept that they are cyclical in nature, but that does not mean that the businesses are inherently low quality or highly risky per se. Unless I see another compelling stock in the construction arena, I will more than likely add Heijmans NV to my portfolio. I am also keeping a close eye on Grafton Group plc and Morgan Sindall plc.

On the basis of the screens undertaken thus far, I am minded to do some more digging around in the following

Group Bruxelles Lambert – Belgian holding company with significant cash firepower trading at deep discount to book value.

Delhaize – Belgian retailer with a presence internationally. Appears to offer reasonable value and a good track record.

Solvay – Belgian listed chemicals company with low valuation, reasonable returns history and strong track record.

Part 2 of this post will look more deeply at the valuation of stocks in Germany, France, Spain and Italy. Some of these markets in particular have some very high weighting of financials in the index. Hopefully there is more on offer to a value investor than some bombed out European banks.

Bricks & Mortar Part 4 – Heijmans NV

Following on from a recent post it is time that I did some more research on Heijmans NV. The company like many in the construction industry was ill-prepared for the economic downturn beginning in 2008. Similar to many, cyclical companies they made the mistake of gearing up late in the cycle. The combination of operating leverage and financial leverage heading into a recession is rarely successful. The Chairman resigned in early 2008, once it was obvious that the writing was on the wall. A rights issue followed in 2009 to reduce the leverage.

Heijmans Valuation

P/B 0.28

P/E (10yr) 3.0

P/E 8.6x

Yield 4.6%

Who are Heijmans N.V.?

The company is incorporated in the Netherlands & has a history that spans over a century. Heijmans is focused across a wide range of construction & property related business, predominantly in the Netherlands, but also in Belgium, Germany and Britain.

According to the 2010 Annual Report, the revenue split is as follows:

Property Development                         14% (0% of operating profit)

Residential Building                           14% (22% of operating profit)

Non Res Building                                  8% (1% of operating profit)

Technical Services                                7% (7% of operating profit)

Infrastructure                                   25% (45% of operating profit)

Belgium                                           7% (4% of operating profit)

UK                                               14% (9% of operating profit)

Germany                                          11% (12% of operating profit)

The company would seem to be in the midst of retrenching from foreign markets, with the exception of Belgium.

With the resignation of the Chairman in 2008, Heijmans recruited a new leader in the person of Rob Van Gelder. I have a long and fond memory of Mr. Van Gelder, in that as a young & inexperienced  equity analyst many years ago, I had opportunity to meet with him several times as I pursued what turned out to be a very good investment in his company,  Royal Boskalis Westminster. My memory of Van Gelder is that he runs a tight ship and is highly focused on margins and cash returns. In my dealings with him over a decade ago, I found him to be straight talking, patient and informative.  Since his appointment, Heijmans has begun focusing on margin over revenue. This may sound obvious, but so many construction and infrastructure companies lose sight of profitability in the quest for iconic projects.

Crisis Timeline

  • A 3% fall in revenue during 2008 leads to a gross profit contraction of 30%,
  • During 2008, Heijmans records a €13.6m operating loss (from a profit of €88m during 2007),
  • EBITDA/Interest Paid coverage falls to 1.2x (Gearing stands at 103%).
  • Chairman resigns & is replaced by Rob Van Gelder,
  • Company announces it will launch a €100m rights issue,
  • Heijmans begins to retreat from overseas markets and begins to refocus on its home market of The Netherlands (plus some business in Belgium).
  • During this time the share price has fallen from €123 in late 2007 to approximately €10 in 2008.
  • Dividend was suspended.
  • 2009: Rights Issue completed and reverse stock split announced. Company makes a further loss during 2009.
  • 2010: Disposal of UK subsidiary, Leadbitter.
  • 2010: Return to profitability. Dividend re-instated. Van Gelder steps down as Chairman and takes up a position on the Supervisory board.

Heijmans ambition is to become the market leader in terms of sustainability, quality and profitability by 2015.

While that is rather prosaic, the reality of the challenge facing management is that revenue in the past year was €2600 million, which was similar to the revenue earned during 2004. Operating profit last year amounted to €48million versus €81million during 2004. The company needs to move ROE from 3.5% to the 11% earned some seven years ago. On an unleveraged basis, returns during 2004 were twice those in 2010.

Can profitability improve from here?

What is interesting about the firm is that the UK has been exited, but it would seem that at a very cursory level, the main drag on profitability would seem to be Property Development and Dutch Non Residential Construction. Both of these areas are barely profitable (if at all). So where are margins, and can they be improved on from here?

Property Development

 Profitability in this division has imploded from 8% during 2007, to break-even during 2010. Profitability depends on the timing and success of projects. During H1 2011, losses increased by €1m from the same time last year to (€4m). The company comments that the market is difficult. This is not unexpected given the broad uncertainty surrounding many European economies at present. Indeed it would be surprising if the any property development business was doing well in the present climate.

The number of houses sold has fallen by 7%, but the inventory of unsold homes has fallen marginally yoy. Inventory of houses under construction stands at 333 as opposed to 377 at the end of 2010.

The issue then is, how much risk as attached to this division until the broader situation improves? In this regard, the financial statements and notes are not much use. As part of the strategy forwarded by management, this division is likely to become a smaller into the future. In many of the financial releases from the company, commentary on the Property Development division seems to blend with commentary on Residential Construction.

Construction (Residential & Non-Residential)

I have looked at these two divisions together as it seems that the company only began splitting them out in 2009. During both 2007 & 2008 this division recorded almost €1bn of turnover in each year. On the back of this turnover margins were -5%. The combined turnover of the division has fallen to €620m in 2010, but the operating margin has improved significantly to 2.9%. The divisional split contained in the 2010 Annual Report reveals that it has been the Residential Construction division that has recovered most. Operating margins have increased from 1.85% to 4.15% between 2009 and 2010. Meanwhile, at the Non-residential side of the business, margins have improved from a loss of 0.9% to 0.4% profit margin. Given the lack of divisional split over the years, I simply have no clear picture as to where these margins stand in relation to their historical trend.

In terms of continued progress during 2011, there has been none really. Residential Construction has made an operating profit of €10m at the H1 stage, which is the same as in 2010 – this is especially impressive given that turnover declined by 15% during the year. At the half year stage operating margins in residential construction stood at 5.6% as margin was prioritized over volume.

The non-residential division has gone from a small profit in H1 2010 to break-even in H1 2011. Revenue has grown by 5% yoy while profitability has gone into reverse – does margin over volume not apply in this division?


 The infrastructure division has actually improved its operating margin in the past 5 years. From a margin of 3.8% on €945m of revenue in 2005, the division now has a margin of 4.8% on revenues of €714m during 2010. Further improvement in the level of profit was recorded at the half way stage this year, with operating profits of €14m versus €10m in the last year, while margin has continued to increase yoy. Turnover has risen by 23%, down to good weather leading to efficiencies in road building). The order book is down.

Technical Services

 As a division, Technical Services appears in the annual reports about four years ago. Since then, the unit has remained profitable. Operating profit margins have fluctuated between 2.4% and 5%. Margins at the half way point this year were 1.1%, which while ahead of H110 margin of 1% are behind the full year margin of 2.4%. Turnover fell by 25% during 2010 and continued to fall this year, with a 9% decline yoy during the H1 results. I can find very little information regarding this division, which is mildly off-putting to say the least.


 The international division used to contain business units in Belgium, Germany and the United Kingdon. Given the exit from the UK division (Leadbitter) the business is now focused on Belgium and Germany. Any infrastructure work in Belgium will be undertaken through the overall Infrastructure division as opposed to the Belgian division.

The UK division has been sold to a JV of Leadbitter management and a French company (backed it would seem by Bouygues. The division has been consistently profitable throughout the past 6 years, with margins improving from 2.3% in 2005 to 3.3% in 2010. Leadbitter has been sold for €47m, which was recognised as a working capital receivable until the sale had completed. Consequently year-end working capital was over stated, and year-end cash was understated by the proceeds of the sale. The sale of Leadbitter has led to a €6m gain on the disposal over the value in the Balance Sheet.

The combined business units of Belgium and Germany generate revenue of approximately €529m at a margin of 2.3%. Similar to other business units within the company, this is a higher margin on lower turnover when compared with 2009. The combined level of operating profit during the first half of this year amounted to a fat zero (from €1m of profit during H110). While Belgium moved back into profitability (2.8% operating margin), Germany reversed its way into a loss.

In the past 6 years, peak margins for both Germany and Belgium are north of 3%.

In terms of profitability, the key to overall group margins improving to the average achieved in the past decade would be for margin uplift at Property Development and Non Residential Construction, followed by improvements in Technical Services and Germany. If this can be achieved there is no reason why Heijmans cannot achieve a group operating margin of 3%. The reality is however that given the state of the property market, it is unlikely that Property Development will attain historic margins anytime soon.

Balance Sheet – P/B implies Asset Overvaluation?

With the stock trading at €7.65 per share, this implies a P/B of 0.28. Such a level of valuation implies that the net assets on the balance sheet are overvalued to a significant degree – is this the case?

Balance Sheet – H1 2011

Fixed Assets 399
Working Capital 338
Invested Capital 737
Equity 458
Provisions 39
Debt 240
Capital Employed 737

I am going to revalue the balance sheet using reasonable discounts to achieve a stressed fire sale price that considers the amount of accumulated depreciation that has already been put through the books.

Heijmans – Balance Sheet  Carrying Value Discount Value
Intangible Assets 181 100% 0.0
Property, Plant & Equipment      
        o/w Land & Buildings (i) 51.0 0% 51.0
        o/w Machinery  42.0 25% 31.5
        o/w Other PPE (ii) 42.0 25% 31.5
        o/w Land under Construction 4.5 10% 4.1
Real Estate Investments (iii) 6.5 25% 4.9
Investment in Associates (iv) 3.4 50% 1.7
Other Investments (v) 70.9 25% 53.2
Current Assets      
      o/w Strategic Land    356 15% 302.6
     o/w Property Work in Progress 160 10% 144.0
     o/w Other Inventory 54 10% 48.6
     o/w Construction Work in Progress 187 10% 168.3
     o/w Income Tax Receivable 7 0% 7.0
     o/w Trade & Other Receivables 377 5% 358.2
Current Liabillities      
        o/w Trade & Other Payables 496 0% -496.0
        Other Current Assets 303 0% -303.0
Capital Employed      407.4
Net Debt     239.0
Implied Equity Valuation     168.4
Current Mkt Cap     124
Difference     36%
(i) Land & Buildings has been depreciated by €43m from the gross B/S value.  
(ii) This relates to PPE beneficially owned under finance leases. They have been depreciated over 3-10 years.  
(iii) Have seen €2.6bn of accumulated deprecation & €0.5bn of impairments.
(iv) Value is the actual equity value, as opposed to B/S carrying value.
(v) Loans to JV’s & other associates.      

I used the Eurostat Property index to judge what type of discount that I should apply to property related inventory. According to this (experimental) index, with the index starting in 2005, the index value for Dutch residential property is 103 currently.

Like any valuation methodology, I will concede that I could use any arbitrary value to fit my thesis. There is no doubt that I could have been harsher. Using the assumptions that I have used I have derived a figure that shows some reasonable upside. What is interesting is the Heijmans closest competitor, Royal BAM Group, trades at 0.55x P/B on a Balance Sheet that contains significantly more debt than does Heijmans. To be fair it would seem that historical ROE’s at BAM are somewhat higher than at Heijmans (but this is not presently the case).

All in all, there is a lot to like about Heijmans in that it meets my primary criteria:

(i) It is good value on which ever valuation methodology that I use,

(ii) Margins on a group wide basis are not at peak levels (though some divisions are),

(iii) The balance sheet is improving.

I will be keeping a close eye on this stock and will look for an opportunity to take a position.

Bricks & Mortar Part 3 (Grafton Group plc)

When dismissing many small cap stocks that I screened as being cheap rather than having value, I was struck by several small and mid cap building and construction stocks that appeared to have all of the characteristics that I am seeking.

For me the ideal investment has a combination of the following

(i) strong valuation characterisitics in terms of asset value, cyclically adjusted PE, cashflow yield.

(ii) a history of having earned sufficient returns and capital to make the business interesting to an equity investor,

(iii) ability for the sales & profitability to grow over time (ie far from peak margins),

(iv) a low risk balance sheet.

My view in this is that the best returns an equity shareholder achieves is when valuations, earnings and leverage are all working in your favour. If I can find many of these characteristics in construction oriented stocks, then why should I not own more of them?

To that end I will be looking at Grafton Group, Heijmans NV and Morgan Sindall plc in greater detail.

Company EV/Sales P/B Gearing G&D PE
Grafton 0.37 0.55 24.3% 5.2
Heijmans 0.08 0.26 52.2% 1.2
Morgan Sindall 0.05 1.06 -56.5% 8.8

There would appear to be a reasonable amount of value on offer. The question then must be, what are the risks? What is the margin of safety? I keep referring to the fact that the market P/B for the broad based MSCI Europe is now at pretty low levels. Now if I were to exclude financials from the market, then there are a pretty small amount of sectors that trade sub book value. Of these construction is the most obvious, in that while it is undoubtedly a cyclical sector there are very many construction companies that have a long hostory of generating strong returns over the cycle. So, it would seem that a P/B of 1 should be a valuation floor as opposed to ceiling. I am not so sure that the same can be said for sectors such as utilities, pulp and paper etc.

Grafton Group plc

I have covered this stock previously, and declined to purchase then. In this post I will take a more detailed look at the valuation and operational dynamics of the business.

The valuation opportunity that presents itself is as follows:

  • Grafton has a thru the cycle RoE of 11%,
  • The average thru the cycle RoE for peers is 5.4%
  • P/B is at 0.56, versus peers at 1.08.
  • P/S is at 0.28 versus 0.44 at peer group.
  • Graham & Dodd PE is 5 versus 22 for peers.
  • Most recent 12mth trailing FCF yield is 12.4%.

By peers I am using the simple average of Travis Perkins, Wolseley and Saint Gobain. By thru the cycle RoE I am using the average ten year earnings per share divided by the most recent book value per share.

A business with yielding 12.4% on margins that are significantly below the cyclical average (let alone) peak, is definitely interesting to me. This is trading at a similar level to many UK retailers and while it has challenges, I am not certain that it faces the same type of operational and financial challenges that many of the UK high street is facing.

Now this is reasonably simplistic level of analysis, and does require further investigation, but it leaves me with the view that if the UK division were to trade on a similar multiple to the peer group, then what you would get the Irish division for free!!

Revenue Split:

  • 71% UK
  • 29% Ireland

Operating Margins

  • UK: 2010 4.1% versus 6.1% average since 2000. H1 2011 margins were 4.5%.
  • Ireland: 2010 0.4% versus 9.1% average since 2000. H1 20111 margins were -0.4%.

The in the past 12 months the UK division has reported revenue of €1450m.

Valuing the UK at 0.4x revenue yields a valuation of €580m which is in excess of the present market capitalisation. Thus Ireland is free on a peer group valuation multiple. 

Key questions

Why is Graftons UK business not appropriately valued (or is it)?

Given the recent margin history illustrated in the chart above, it would seem reasonable to value Graftons UK business on a revenue and profit multiple that is similar to Wolseley and Saint Gobain at the very least. Below I submit a basic sum of the parts valuation. I generally dislike the SoP method as it is so arbitrary. Despite the flaw, it does help to capture the undervaluation of the Group, given that the UK business could in theory be valued at the same value as the market capitalisation of the firm. (The is a difference betwen mkt cap and EV< that in this case is about €232m.

Grafton UK Valuation €, mill Peer Multiple Implied Valuation
UK Revenue 1450 P/S 0.37 536.50
EBIT Margin 4.5%      
UK EBIT 65.3 EV/EBIT 9.45 616.71
Share of Depreciation 28.0      
UK EBITDA 93.3 EV/EBITDA 5.85 545.76
Average       566.32
Mkt Cap       564.79

To really crystalise value, Grafton must improve operating margins. While they continue to improve EBIT Margins remain at the lower end of the peer group average. Furthermore, while Grafton does not split out Gross Margin by division, it does appear that most of the heavy lifting needs to be done at the level of operating expenditure. Gross Margins are relatively unchanged from the average gross margin level achieved over time.

To put this into context, since revenue and margins peaked in 2007, Sales have fallen 37.5%, CoGS has fallen almost 36%. During the same time period Operating Expenses have fallen 24%. While the company is trying too cut costs, it does seem that the level of fixed costs is too high for the present level of revenue.

Grafton has cut out a large amount of operatig expenditure in terms of the absolute € amount of costs. Unfortunately, given the decline of revenue it has not been sufficient to fully protect margins.

Staff costs have averaged 13.8% of revenue versus 15.1% during FY 2010. This is despite €124m of costs been taken out (that means job losses – there is a human cost to all of this). SG&A costs have averaged 8.3% over time, versus 9.0% for 2010. Once again this is despite €63m in costs taken out. If I accept that the present cost bases is both fixed and necessary, then revenues would need to grow by 11% to €2.22 billion to return to the average level of margins.

There is a glimmer of hope in the the H1 2011 results revealed that revenue grew by 3% on the year (Not enough, but a start) and operating costs declined such that EBIT grew by  40%. Costs continue to be taken out of the business, slowly but surely. Despite lacking a detailed breakout of costs between each division, it would seem that the UK division is making reasonable progress toward median margins. The problems in Ireland however are not improving. The division remains loss making.

What is Ireland worth?

 Ireland now accounts for almost 28% of revenue and is presently loss-making.

  • Revenue decline since peak:           -53.0%
  • Cost decline since peak:                    -47.3%
  • Profit decline since peak:                  -98.3%

Having reported a small profit in 2010, the Irish business has slid back into loss during H1 2011 as revenue declined by 7.7%. It is too early to say whether a bottom has been reached in terms of revenue outlook. My own suspicion is that Grafton in Ireland is simply operating from way too many outlets even now. I would imagine that some serious surgery is required on the size of the retail estate.

The reality with Grafton is that upside will come from attaching a higher valuation to the Irish portion of the business.

Size of DIY Retail Estate in Ireland

2011: 2.6m sq ft

2010: 2.6m sq ft

2009: 2.6m sq ft

2008: 2.6m sq ft

2007: 2.5m sq ft

2006: 2.3m sq ft

2005: 2.2m sq ft

Now it should be said that not all of the Irish division is accounted for by the DIY division. But the fact that the size of the retail estate has not changed since the market peak while revenue has collapse, would indicate that much should be done to address the cost base. The question then becomes, can something be done?

According to the annual report, there is €900mof operating lease committment due over between 2011 & 2015, with a current year lease rental charge of €59m.  To generate a 5% operating margins from the present cost base, revenue would need to grow by 6%. It would seem that we are a while away from that just yet. During H1, one lease has been exited by the company.

Irish Outlets 2007 2008 2009 2010
Merchanting  79 79 71 67
Manufacturing 4 3 3 3
Retailing 47 48 48 49

It does appear that very little has been done to seriously address the size of the Irish estate. I find it difficult to believe that profitability can recover without rightsizing the business. If managment grasp this issue, I believe that margin and valuation upside could indeed be considerable.

Cashflow and Balance Sheet

The company has done an admirable job in defending cashflow during what has been a torrid time for the company. Much of the efforts to defend cashflow have come from impressive improvements in working capital management. Working Capital/Sales has fallen from 16% at the market peak to 11.5% in the last fiscal year. The company continues to spend on acquisitions and expansion capex (predominantly in Belgium and Poland). This is no bad thing. A reasonable balance sheet and solid cashflow profile supports this, so I see no reason as to why the company should shut up shop on that front. Grafton does split out capex between maintenance capex and expansion capex. That is useful, in that it helps me gauge what a steady state for the business maybe.

Since 2007, creditor days have expanded from 57 days to 73 days. Debtor days have fallen from 61 days to 55days, while inventory days have risen from 65 days to 72 days. All in all the amount of working capital required to finance revenue has declined by €250m. The biggest cash saving has come in the form of pushing out creditor days. I would not bet that it is possible to increase this, furthermore given that many clients are builders and developers I am wondering how much of the debtors book is impaired?

Free cashflow has declined from €194m in 2007 to €75m in 2010, while maintenance capex has declined from €52m to €6m in 2010. I could never understand just how flexible supposedly maintenance expenditure could be. What is admirable however is that the company has continued to generate positive cashflow throughout a very significant compression of business activity.

So, what is this cashflow worth?

I use an backward DCF to estimate what cost of capital is being applied by current cashflow assuming that the cashflow grows into perpetuity at a rate of 0%, 1% and 2%.

FCF 74874 Ke 10% 11% 12%
Net Debt 193376 G 0% 1% 2%
Market Cap 557711   750993 750971 751318
EV 751087   0.0% 0.0% 0.0%

I often use DCF’s as a gauge of what is being implied by a share price under as opposed to a predictive tool that depends on a series of ever increasing optimistic assumptions. SO, over time should the average level of cashflow increase and the cost of equity fall, then there could be considerable upside (. . .and vice versa obviously).

The balance sheet is in reasonable shape, with Grafton having spend much of the past 4 years reducing the amount of debt that it has.

Gearing 30.5%
Gearing(incl Leases) 127.5%
Int Cover 9.68
Fix Charge Cover 1.97

 Once lease agreements are factored in, the balance sheet is considerably less strong than first appears however. Credit is due however in that the debt outsatnding has been reduced by €230m in 4 years from cashflow despite a deteriorating operating environment. In addition to the amount of debt been reduced, the maturity of remaining debt has been extended.

Banking covenants are generous in that they allow gearing up to 85% and minimum EBITDA Interest cover of 2x, extending to three times in 2012.

Technical Position

Grafton share price chart

The chart linked above is the most recent price action on Grafton Group. There is a steady shallow downtrend that is in the process of beginning. New recent lows being opened up followed by reasonably uninteresting upmoves. There is some support between 2.15 and 2.40, but following the line of least resistance I am of the opinion to see does it trend toward that level. If that support does not hold, then that would open up the possibility of revisiting the Q1 09 lows – now that would become really interesting from a valuation point of view.


Grafton hasa lot of what I want from an investment:

  • Significant upside potential from positive operational leverage,
  • Reasonably attractive valuation,
  • A much improving balance sheet (2010 F Score was 6, and that improved to 7 on the basis of analysing the interim results).

However I am not moved to buy right now.

  • Deteriorating technical picture,
  • A margin of safety exists, but not an exceptional one given the ongoing risks in Ireland,
  • I have an issue with managemet strategy regarding the Irish retail division (but I except that similar to many retailers they are locked into expensive lease agreements).

I will remain watching, hopeful that I can pick up some stock around €2.15, if not much lower.


Heijmans NV (HEIJM:AEX)
Share Price: €8.14

P/B: 0.3

Graham & DoDD PE: 3.1x

P/S: 0.05

Gearing: 48% (Interest Cover 4.8x)

F-Score: 8

Heijmans is a listed Property Development, Residential Building, Non-residential Building, Technical Services and Infrastructure company. Outside the Netherlands, Heijmans operates in Belgium and Germany.

In many of the screens that I run, Heijmans, a small cap Dutch construction company keeps appearing. The company has had a torrid time in the past number of years, and required an highly dilutive rights issue during 2009 in order to reduce leverage and shore up the balance sheet. The company has returned to profitability and is once again producing cashflow. A Piotroski score of 8 at the last annual report date indicates that the financial postion is improving. This looks so appealing, on so many fronts.

I will need to do further research, but much of what I see thusfar is exactly what I am looking for in a stock.

Morgan Sindall

Morgan Sindall is a UK housebuilder and construction company.  While not as downright cheap as either Heijmans or Grafton, it has a fortress balance sheet and is paying out a substantial amount of cashflow in the form of dividend. Despite having a balance sheet that is heavy with net cash, the median ROE over the past decade has been 21%. All told Morgan Sindall is a stunning company. I need to delve a little further in that I have much to learn with regard to the affordable housing sector – an area that contrubutes a sizable portion of the companys cashflow and returns.

With 53% of the market capitalisation as net cash, I can purchase this company now for book value (yielding 7.6%). This is not a cost of capital business. On the vasisi of a simple DCF or reverse engineered Gordon Growth model, I see no reason why this company should not be valued at twice the present valuation.

I am thinking of Grafton, Heijmans and Morgan Sindall in terms of an investment in small cap European construction related companys. It would be my goal to purchase equal size positions in all three – the thinking being that the lower risk balance sheet of Morgan Sindall acts as a nice counterweight to the riskier ‘recovery’ plays of Grafton and Heijmans.

As usual, comments greatly appreciated.

Telecoms – are the present dividends sustainable?

With dividend yields of large cap integrated telecom operators in Europe at high single digits, it is worth taking an historical look at the cashflow statements and balance sheets in order to ascertain just how sustainable the present dividends per share maybe.

Stock Mkt Cap Div Yield
Belgacom €7500m 9.7%
Deutsche Telekom €39000m 7.8%
France Telecom €32000m 11.7%
KPN €13200m  9.0%
Telefonica €61.1m 10.6%
Vivendi €19.8m 8.8%

I will be attempting to decide if any of the aforementioned are investible from the point of view of dividend sustainability. Are these dividends stretched, or are the yields the result of low share prices? Intrinsically I dislike telecoms stocks. They always appear good value on cashflow multiples. But they have two traits that I am wary of. Telecoms are highly regulated and appear to be deflationary. I cannot see how either of these are my friend as an investor.

If these are no growth equities, but the dividends are sustainable, then maybe they have a place in a portfolio in lieu of holding  government bonds or bank deposits?


The Belgian integrated telecom operator has one of the highest divided yields in the space.

Stylised Cashflow Statement

% of Sales FCF Statement 2009 2010 Avg.
Net Income 15.3% 19.3% 16.3%
Non Controlling Interest 0.0% 0.3% 0.8%
Depreciation & Amortization 11.9% 12.3% 12.7%
Other Non Cash Charges 1.1% 1.7% 1.4%
Disposal (Gains)/Losses -1.3% -6.7% -2.9%
Op cashflow pre Working Capital 27.0% 26.9% 28.3%
Change In Working Capital -3.2% -1.5% -1.1%
Net Cash Inflow 23.7% 25.4% 27.2%
Capital Expenditure -10.1% -11.2% -11.4%
Free Cashflow 13.7% 14.2% 15.8%
Dividend 11.6% 10.7% 11.4%
Dividend Cover 118.3% 132.8% 139.1%

Over the 6 years of data analysed, there is reasonable stability in Belgacoms cashflow metrics. As long as revenue does not deteriorate dramatically then the dividend would appear to be sustainable on the basis of the cash the the company normally generates.

In terms of the Balance Sheet, I find that at the end of the last fiscal year, the company had debt/equity of 102% with an EBITDA Interest Coverage ratio of slightly under 24x.

At the Q3 stage this year revenue was down 3%, and EBITDA was down 1.6%. Capex was down 3%, but more importantly FCF was down 10%. On an annualized basis this would put cash dividend cover at approximately 1.18x. Ideally ome would wish a higher level of dividend cover in order for the dividend to be able to withstand shocks.

5 year Total Shareholder Return: 3%


Deutsche Telekom

DT has been a bit of a perennial dog since the bust of the TMT bubble. However, each year it cranks out a large dividend that is presently well covered by cashflow.

% of Sales FCF Statement 2009 2010 Average
Net Income 1.4% 3.2% 4.2%
Depreciation & Amortization 21.5% 17.6% 19.3%
Other Non Cash Charges 1.6% 4.5% 0.4%
Disposal (Gains)/Losses 0.0% -0.7% 0.0%
Net Cash Inflow 24.4% 24.6% 23.9%
Capital Expenditure -14.2% -13.9% -15.3%
Free Cashflow 10.2% 10.7% 8.6%
Dividend 6.6% 6.3% 5.9%
Dividend Cover 153.8% 168.1% 144.8%

It is worth noting that cashflow did not cover the dividend during 2006, but the dividend was not cut.

The balance sheet is not as strong as that of Belgacom, with gearing of 248% and interest cover of 7.4x. Now it would appear that DT spends more on Capex on average than Belgacom.

5 year Total Shareholder Return: 4%


France Telecom

In spite of the very high dividend yield at FT, it would appear that recent cashflow generation has been stable and is more than sufficient to cover the dividend payable.

% of Sales FCF Statement 2009 2010 Average
Net Income 7.6% 10.7% 10.0%
Non Controlling Interest 0.0% 0.0% 0.0%
Depreciation & Amortization 15.4% 14.2% 15.3%
Other Non Cash Charges 6.0% 4.8% 4.2%
Disposal (Gains)/Losses 0.0% -2.2% -1.9%
Opcashflow pre Working Capital 29.1% 27.5% 27.6%
Change In Working Capital 2.2% -1.4% 0.5%
Net Cash Inflow 31.2% 26.1% 28.0%
Capital Expenditure -12.2% -13.4% -13.4%
Free Cashflow 19.1% 12.7% 14.7%
Dividend 7.0% 8.1% 7.3%
Dividend Cover 272.2% 155.6% 217.6%

According to the companys outlook statement the goal for the period from 2011-13 is to generate EBITDA of €45bn and spend capec of €18.5bn. These figures are very similar to what occurred from 2007-10. If achieved it should lead to a situation where the dividend is sustainable into the near future. The only thing to scupper this is that EBITDA at the 9 month stage for 2011 is down 5.2% yoy.

 5 year Total Shareholder Return: 2%



% of Sales FCF Statement 2009 2010 Average
Net Income 15.1% 17.3% 15.1%
Non Controlling Interest 0.0% 0.0% 0.0%
Depreciation & Amortization 17.4% 16.7% 18.7%
Other Non Cash Charges -4.5% -6.0% -4.1%
Disposal (Gains)/Losses 0.0% 0.0% 0.0%
Op cashflow pre Working Capital 28.0% 28.0% 29.8%
Change In Working Capital 0.1% 0.6% 0.6%
Net Cash Inflow 28.1% 28.6% 30.4%
Capital Expenditure -13.2% -16.1% -13.1%
Free Cashflow 14.8% 12.5% 17.3%
Dividend 7.7% 8.6% 7.8%
Dividend Cover 192.1% 144.3% 222.0%

FCF dividend cover is reasonably sevure at 1.4 times but has fallen sharply in the past number of years. If capex begins to fall these numbers may improve.

5 year Total Shareholder Return: 23%



Telefonica is one of the largest quoted integrated telecos trading globally. Like many large Spanish companies, it has made a specialism of frequent M&A activity.

% of Sales FCF Statement 2009 2010 Average
EBITDA 39.8% 42.4% 39.7%
Adjustment -9.0% -7.9% -7.2%
Non Cassh Items -2.2% -7.7% -3.2%
Operating cashflow Before Working Capital 28.6% 26.9% 29.3%
Change In Working Capital 0.0% 0.0% 0.0%
Net Cash Inflow 28.6% 26.9% 29.3%
Capital Expenditure -13.4% -14.7% -13.4%
Free Cashflow 15.2% 12.2% 15.8%
Dividend 8.5% 10.3% 9.3%
Dividend Cover 179% 119% 171.7%

5 year Total Shareholder Return: 23%



  • Dividends at the largest European integrated telcoms are presently covered by cashflow,
  • That cashflow coverage is in some cases is well below its average over the past 6 years,
  • If the next five years looks like the last five, then there is no reason for any dividend to be cut,
  • Dividend alone is not sufficient reason to make me want to invest,
  • In many cases operating cashflow and capex is actually reasonably stable,
  • In a low return environment they have just about served their purpose in providing a positive total return, (I would be fearful of their returns in an era of high returns and high inflation).
  • Despite the seemingly FCF yields on offer, I think that it is right that low/no growth regulated firms should trade at such levels.

Ugly Ducklings . . . or Baby Swans?

In a recent trawl of several valuation screens, I keep seeing the same names appear again and again and again. They are an hodge podge collection of various small caps across Europe (are any of these baby swans, or are they perennial ugly ducklings). At first glance some of them look to have been stuck in the loserville for a very very long time (eg Psion and Agfa Gevaert) , whether any of them are in any way interesting for me to invest in.

I should say that after my last post regarding Total Produce, that I have taken a position in the stock in the region of 5% of my own fund.

Dart Group



Morgan Sindall

Agfa Gevaert



Grafton Group

 . . . and a host of UK Retailers and various banks across Europe.

As well as showing up in some screens, Kontron and Psion were were suggested to me by an acquaintance of mine. I have already studied Grafton and Morgan Sindall. I think that Morgan Sindall seems to be in much better shape from the point of view of  returns and cashflow but will to delve a bit deeper. I have no doubt in my mind that Grafton represents great value. I am worried that margins superior margins in the Irish business will not be achieved at any time over the next five years. However the UK business is a fine business. This stock will be of interest to me at some stage, just not now.

UK Retailers – the carnage continues, but does Mothercare present an opportunity?

Since I last posted, several more UK retailers have issued abysmal trading statements, that should by now be expected by the markets. Game Group in particular seems like a company at deaths door. It would not surprise me in the slightest if fixed charge cover slides below 1 by the next trading statement. If that  comes to pass then it is almost certainly goodnight for the retailer.  Game is HMV/JJB waiting to happen.

Mothercare issued its interim results on Nov 17th. In spite of the stock falling a further 18% (to bring the full year return to -75%), I actually find some comfort in the results. The company has written down goodwill and has taken a cash charge to accelerate the exit of 110 of its property portfolio. This is a brave move and one that I believe can pay dividends and create value for shareholders. If I was to part with hard cash for a UK retailer it would be Mothercare.  There is a growing and viable international business that is highly profitable. It alone is worth several times the market capitalisation of the entire group. In the run in to Christmas that UK sales will continue to get worse.

If only the management of Home Retail would bite the bullet and begin a net closure of stores. If they are not prepared to do this, I feel it is only a matter of time before either the market in terms of an activist or their creditors force them to do it. The present management team has no credibility in my eyes, that is what differentiates them from the Chairman of Mothercare in my opinion. Mothercare for me is a question of trying to decide when is the appropriate time to invest in this situation. If Mothercare was to completely write off the UK business and sell it for a minimal amount (a la Kesa with Comet), then I still believe the upside is significant (ie greater than 100%).

I am convinced that there is also significant upside to play for in Home Retail, but the stock needs a catalyst.

Market Valuation

The  fact thatmuch of the equities trading on attractive multiples tend to be found in generally poor companies or poor industries, suggests to me that the market is not such great value. There are exceptions such as integrated oils and large European cement & aggregates companies, but too often the value end of the market is monopolised by banks, utilities and an assorted collection of small cap misfits.

I recall that in Q1 2003 and again in Q1 2009, many very high quality companies traded at pretty distressed multiples. That is what I am am patiently waiting (and hoping) for. I want to be able to purchase a host of strong companies with attractive capital and income characteristics at or below book value on a cyclically adjusted PE of 10 or less. Why eat soggy chips now, when if I wait I could have the finest steak and lobster tail!!!

While the Eurozone equity markets are approaching levels of attractive valuation, the breadth of that valuation is pretty poor. This supports my view that from here compound returns in general will be poor over the next 3 years or so. I do believe that if this trend continues that the market will hit generational valuation lows in that time frame. The chart below of the trailing P/B of MSCI Europe goes some way of showing just how attractive Eurozone markets are. I am sure that the low valuation is driven in a lrage part due to the ewightings of banks, insurance and utilities in the market indices.

Ducks or Swans?

Kontron AG

Kontron claims to be a global leader in embedded computing technology. Quoted in Frankfurt with a market capitalisation of €288m. In the past few years, an activist investor (Warburg Pincus) has taken a 10% stake. Despite that Kontron seems to be a pretty mediocre company. In looking at ten years of financial data, it strikes me that (i) Net Operating cashflow fluctuates between 3.5% & 5.1% of revenue. (ii) FCF is volatile jumping between large negative and slight positives. In the past decade only €38m of FCF has been generated. (iii) Median RoE & RoA is a lowly 4.6%  & 6.4% respectively. 

Gross Margin: Median 32.8%. Range 27.9%-38.8% 

EBIT Margin: Median 6.3%. Range 0.5% – 8.5%

Average net operating cashflow has been 4.9% of revenue, with capital expenditure running at an average of 3.4% of revenue. All in all this is a company that when it gets things right, does not produce a significant amount of cashflow.

With 40% of employees engaged in R&D I would expect that returns and eventually cashflow to be much higher than they are, unless the company is engaged in early stage development.  This poor returns are maybe due to company specific factors (which maybe Warburg Pincus believe they can fix) or industry factors, which are less likely to be resolved.

Since 2000, there have been gains or losses that are non operational made in every year, with the sum total of these being a below the line cost of €39million.

The business is improving this year in that margins are up across the board. The top line is growing at 22%. While the order bookappears to be in resaonable shape, although down on last year. Gross margins declined by almost 1% to 29.2% but EBIT margins have moved from 4.5% to 6.6%. Despite the margin improvement in the 2010 annual report the management guided on EBIT margins in the range of 8%-9% for this year. Pretax margins increased significantly as losses last year were not repeated this year. These losses relate to a risk provision that was raised for a fraud that was alleged to occur in SE Asia.

All this time the shares have continued to sink.

Using a stylised FCF model, where I simply look at margin and working capital improvements I get an FCF statement that looks something like this

Stylised FCF  
EBITDA Margin 9.7%
Tax @ 26% 7.2%
Working Capital * -1.8%
Net Operating Cashflow 5.4%
Capex/Sales -3.4%
FCF (as % of sales) 2.0%
Asset Turnover 96.4%
Asset/Equity 147.0%
Sales 534.95
FCF 10.8
Cash RoA 5.2%
Cash RoE 7.7%
FCF Yield 3.7%
* Assumes Revenue growth at 5% and Working Capital to sales improves to 32%  

Now I have no idea why Warburg Pincus have started stake building. They obviously believe that  they can improve this business and release value. Best of luck to them. To have confidence that value exists one needs to believe that present improvements can continue to be improved upon and that these improvements are sustained. However, when I run a simulation that ramps up margins and runs down working capital, then this is simply not that interesting a business from a cash or returns point of view. Top line growth is great, but it mens very little unless it can be monitised.

For me to believe that there would be a significant compounding opportunity, then I have to envisage a future that has not happened at any time this company’s past. That is not something that I am good at.

If it walks like a duck, and quacks like a duck . . . then it is unlikely to be a swan!

Psion plc

Psion has a market cap of £73m and is listed on the London Stock Exchange. Similar to Kontron, an activist investor has recently taken a stake in the company. Psion is a market leader in hand held ciputing devices for industrial usage (predominantly the logistics and distribution sectors). The company trades below on EV/Sales of 0.23, an EV/EBITDA of 3.5, P/B of 0.4 and a 7% dividend yield. The company has net cash on the balance sheet that is equivalent to 45% of the market capitalisation. Finally the present value of Psion is 1.4x its net working capital. All of this is a long way from the tech bubble when the share price grew from 242p to 2792p. (Hopefully we will see that type of madness in the equity markets once more!!!).

Psion has had a pretty chequered history. The financials over the past decade look appauling. Revenue has grown over the decade, however gross profit remains unchanged as margins have fallen from 52.6% to 38.2%. Operating margins have expanded, but similar to Kontron, Psion is a low margain and low cash generative company. Very similar to Kontron, for me to have any interest in Psion, I must have confidence that the new growth can drive margins and cashflow. In saying that, Psion does appear to be cheaperthan Kontron. Cheap is appopriate here, as there is a significant difference between what is cheap and what is good value. Having not delved deeply I wonder does technological change in the mobile dvisices/computing market mean that (i) margins will always be under presseure as there will always be a declining legacy product of some description and (ii) other than having a rugged exterior, why do the devices offer that a smart phone/tablet couldnt offer?

My initial impression is that due to significant working capital and capital expenditure conditions, then in order to consitently deliver cashflow at a reasonable level, then the company needs operating margins in excess of 9% on my calculation.  I cannot find any time in its history that Psion has achieved this.

This has none of the characteristics of a swan.

Dart Group

Dart Company has a market capitalisation of £96m and is quoted in London on the AIM. The company has two distinct businesses

* An aviation business which is a low cost airline operator and charter airline specialist

* A distribution business which specialising in the transport of fresh food produce to UK supermarkets.

Dart Group is profitable and reasonably cash generative, and has been for much of its recent history as far as I can tell. The stock has had attention from other bloggers, namely Expecting Value and ValuehunterUK recently. The stock is attractively valued in that it trades at 0.62x tangible book value. In terms of more earnings based multiples , the company is trading on a trailing 12 month EV/EBITDA of 1.3x. Net cash on the balance sheet represents 63% of the market capitalisation. Also, the Chairman/CEO of the company owns 33% of the shares outstanding. Now it is nice to see such prudence on a balance sheet, but the hoarding of cash almost never creates shareholder value.

Dart operates to my mind in a business with very low barriers to entry. With 86% of profitability being generated by the aviation business then it is fair to compare Dart to Ryanair or Easyjet. Ryanair is a fantatsic business to my mind, and I have huge regard for how management have run the company in what is a dire industry for equity investors.  However Dart is trading at between a 60% and 90% discount to Ryanir on asset or earning multiples on initial analysis.

There are about £100m of operating lease committments that arise over the next 5 years, so I really should add these back to EV to get a more realistic appraisal of value. In this case, the company trades on an EV/EBITDAR of 2.8x. In terms of context Easy Jet and Ryanair trade on EBITDAR multiples of 4.0 and 6.0 respectively.

Given the cash genrative nature of the business, I will be doing some more work on this stock despite the highly competitive nature of the industry that they operate in. May actually be a swan, its not that ugly, is it?


Safestore is the largest UK provider of self storage and is the second largest self storage operator in Europe. The company is listed on the London Stock Exchange where it presentlty has a market capitalisation of £197million. The stock trades on a P/B of 0.72x. The company is reasonably highly geared at 178%. Not unexpected given that the underlying asset is property. Fixed charge cover would appear to be 2.1x.

The company is highly cash generative at the net operating cashflow line. Approximately 10-12% of net assets are generated as cashflow. In the past few years all of this cashflow has been spent on capital expenditure. Despite considerable capex in the past few years, there has been no expansion in revenue or profits. Now maybe capex is cyclical, if it is, then there is certainly opportunity in that 25% to 28% of revenue translates into net cash earnings. I see no reason why a company should have to spend a similar amount on a regular basis in capital expenditure. It is fair to expect that such an amount of expenditure should generate revenue, profits and ultimately cashflow. For me to be convinced that this is a viable investment, I would need to see a consistent cashflow stream after capital expenditure.

The opportunity with Safestore plc is that occupancy is only 59%. If this can be increased then cashflow will grow. I wonder why capex would be so high when occupancy is 59%. Now, I am assuming that with self storage depots that 90% plus occupancy rarely occurs – so I need to ascertain what is normal or achievable.

Morgan Sindall & Grafton

Morgan Sindall is a UK construction company that operates perdominantly in building regenration and affordable housing. I looked at the company previously and shied away, not on quality grounds but on the grounds that I was/am nervous of the dependency of many UK construction companies on affordable housing. Any area of business that reuires the Government to support your business could find itself the victim of the latest fashion of austerity for everybody, everywhere.

In saying that, I must confess that from all of the metrics that I have analysed, Morgan Sindall does appear to be a very successful company with a string track record in value creation.  Net cash is half of the market capitalisation. Over time the company has generated an RoE of 20% on average, on an ungeared balance sheet!!!

Net Cash RoA has averaged 9%. All of this for a company that presently trades on a P/B of 1.06 and a FCF yield of 12%. The company has a strong dividend policy and presently yields 7.6% on the basis of an admittedly high 60% payout ratio.

Grafton is an Irish quoted Builders merchant and DIY retailer. It is the leading player in Ireland and a top three player in the UK. Margins are well below long term history due to ongoing market difficulties. But this business screams operational leverage to me. Valuation in terms of longer term metrics is deeply depressed.

When I look at companies of the ilk of Morgan Sindall, I wonder why on ever do I bother to even do some work on the likes of Kontron etc. Morgan Sindall is no doubt a cyclical company in a cyclical sector. But it is not a ‘hope’ stock. Given its recent pull back and the paucity of higher quality companies in the value space, I will be focusing a lot of attention in the near future on both Morgan Sindall and Grafton Group once again.

Both of these companies are trading in my opinion on very much undeserved multiples. Both represent great value, one is more stable near term than the other. When I started re-investing in equities (investing as opposed to trading) at the tail end of the summer just passed, I started with the aim of seeking companies that could grow the valuation as earning and gearing grew back to normalised levels. Both Grafton and Morgan Sindall have this in spades – it is simply a timing issue. Kontron and Psion require me to hope and believe in a future that is significantly better than any past that they have had. I am sceptical of such situations. As a person who is inclined to believe that the glass is half empty, I just dont do optimism and hope all that well.


Agfa Gevaert

This stock has declined 73% in the past year, and has been a dog with fleas for the best part of a decade at the very least. Technical obsolesence is very difficult for any firm to deal with, unless one has a deeply diversified product portfolio. With a market capitalisation of €202 million and a working capital less net debt equal to €490, this stock represents a very rare Graham Net Net.

There was an equity issue in the past year to repair a highly leveraged balance sheet. Operating cashflow mproved very significantly during 2009 and 2010, but has deteriorated thus far in 2011. Valuation alone will compell me to do some more work on this issue.

Has spent much of its life behaving as an ugly duckling. More than likely not a swan, but the valuation seems to scream for further attention.


Value investing involves threading a fine line. There is a difference between assets that thrade on low multiples and are cheap, to assets that represent good value for a patient investor. I do not think that you can depend on hope for value to work. Hope is more in the realm of speculation, and I have that with my recent purchase of  Bank of Ireland and can add to it if I decide to go ahead and part with cash to buy Mothercare.

Having looked at a lot of screens that throw out deep value names, I find that there are may lowly priced equities but only a few to which I would suggest that have value characteristics. I aim to make a closer analysis of Morgan Sindall plc and Grafton Group plc. Morbid curiousity attracts me to doing some work on Agfa Gevaert.

Other than that, I aim to investigate just how much value there is in mage cap technology stocks. Several well known value investors have taken large stakes in companies such as Microsoft, Hewlett Packard and IBM. I want to see where they are in terms of their very long run valuation history. I also think that I will have a peak at just how sustainable some of those dividend yields in European telecom stocks are. Finally I have been mulling over Transocean recently. I like oil plays as a longer term story, and this infrastructure play seems to have suffered from a very significant level of multiple contraction.

Fruit and nuts

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 screening tool. 

Stock P/B Int Cover Gearing RoA             (5 yr avg) RoE             ( 5 yr avg)
Arcelor Mittal 0.53 7.4 31% 5.40% 11.20%
Benetton Group 0.49 46 34% 4.80% 9.40%
Finmeccanica SpA 0.42 3.5 46% 2.60% 11.30%
Gdf Suez 0.72 5.3 40% 3.80% 9.80%
KSB 0.58 9 16% 7.20% 17.60%
Nexity 0.58 17.5 12% 2.80% 6.20%
OMV 0.85 14.7 32% 6.80% 15.30%
Saras 0.85 7.80 32% 5.20% 13.70%
Dart Group 0.66 38.4 6% 4.50% 15%
Grafton Group 0.68 3.2 33% 4.90% 11.70%
Kontron  0.89 19.6 12% 5% 21.70%
Total Produce 0.67 4.1 33% 3% 9.20%

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.

Greenblat Screen

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.

Company Name P/B P/S Gearing  FCC
BMW 1.5 0.5 -36 14.4
Dart Group 0.7 0.2 -66 1.8
Morgan Sindall 1.1 0.1 -64 1.8
Inchcape 1.1 0.2 -19 4.4
Drax 1.5 0.8 -21 14.4
Salzgitter 0.8 0.4 -32 3.4
Clarkson 1.5 0.9 -123 6.1
Skanska 2.4 0.4 -43 10.8
Sportingbet 2.1 1.1 -67 15
Total SA 1.5 0.6 24 23
Robert Wiseman 1.8 0.3 3 8.9
Dragon Oil 1.7 4.6 -64 999.9
Boliden 1.5 0.8 21 34.5
Indesit 1.6 0.3 32 11.7
Jungheinrich 1.1 0.4 -31 2.7
Balfour Beatty 1.6 0.2 -37 2.4
OMV 0.9 0.4 45 8.3
Meyer Burger 1.9 1.5 -61 13
Maire Tecnimont 2.1 0.4 -51 3.7
Andritz 3.3 0.7 -145 8.8

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
Helphire 11 0.19
SOLON 22 0.22
Phoenix Solar 36 0.23
Barratt Developments 930 0.41
PV Crystalox Solar 39 0.44
Heidelberger Druck 304 0.53
Agfa Gevaert 290 0.58
Taylor Wimpey 1301 0.63
Praktiker 156 0.66
Q-Cells 121 0.68
Findel 80 0.68
Gleeson (M J) 67 0.75
Molins 23 0.80
Abbey 114 0.83
Bovis Homes 722 0.86
Salzgitter 2071 0.89
Harvard Intl 22 0.95
Vislink 22 0.95
Redrow 402 0.98
Persimmon 1712 0.99

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?


  2005 2006 2007 2008 2009 2010
Shares Out 348971 349951 351003 351887 351887 351887
Share Price 0.76 0.76 0.59 0.26 0.34 0.38
Mkt Cap 265218 265962.8 207091.8 91490.62 119641.6 133717.1
P/E 19.9 37.7 10.9 6.0 9.2 7.3
P/B 1.60 1.80 1.26 0.63 0.72 0.79
P/TanBV 3.09 5.16 5.16 3.59 3.15 4.78
Div Yield 0.0% 0.0% 2.7% 6.5% 5.0% 4.4%
P/S 0.196 0.169 0.096 0.041 0.055 0.057
EV/Sales 0.210 0.168 0.143 0.085 0.091 0.090
EV/EBITDA 6.6 8.0 6.0 3.9 4.5 4.2
FCF Yield 6% 3% 17% 37% 21% 23%

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.

  2005 2006 2007 2008 2009 2010
Sales Growth   16.3% 36.4% 4.7% -2.9% 7.2%
Gross Profit Growth   22.2% 30.2% 3.1% 1.6% 6.2%
EBIT Growth   -32.5% 72.3% -6.2% -10.7% 17.5%
PreTax Growth   -36.2% 75.3% -10.1% -4.9% 18.4%
Gross margin 13.5% 14.2% 13.5% 13.3% 13.9% 13.8%
EBIT Margin 2.4% 1.4% 1.8% 1.6% 1.4% 1.6%
Tax Rate 31.4% 28.3% 27.1% 28.4% 32.3% 24.9%
RoE 8.1% 4.8% 11.6% 10.6% 7.9% 10.9%
RoA 1.8% 1.2% 3.0% 2.5% 1.9% 2.4%

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:

FCF 25043 25043 25043 25043 25043 25043
g 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
Ke 8% 9% 10% 12% 14% 16%
EV of FCF 313037.5 278255.6 250430 208691.7 178878.6 156518.8
Net Debt -77776 -77776 -77776 -77776 -77776 -77776
Equity Value 235261.5 200479.6 172654 130915.7 101102.6 78742.75
Value/share 0.71 0.61 0.52 0.40 0.31 0.24
Upside/Downside 87% 60% 38% 4% -19% -37%

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)

Operating Profit 1.55%
Depreciation 0.63%
Impairment Charges 0.26%
FV Movement on Inv Prop 0.00%
Amortisation 0.21%
Other Non Cash adjustments -0.02%
Pension adjustments -0.13%
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%
Capital Expenditure -0.76%
Free Cashflow 1.22%

 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?



UK Retail Redux

Quarter in, quarter out for some time now, the results emanating from UK quoted retailers make for dire reading. I have looked at the sector in some detail due to what is an extraordinary low level of valuation. I have not been willing to part with any hard cash and actually invest in the sector due to what are structural weaknesses, significant lease committments, questionable strategy and a poor outlook for UK consumer spending. I am of the opinion that the UK has way too much retail real estate. An aggressive management team or an activist approach by shareholders could well unlock some value in the sector.

Home Retail

I cannot understand the strategy being followed by the Home Retail management team. I have written previously that I believe it is reckless and puts the balance sheet at risk for no obvious reward. This mornings h1 results from the company, encapsulates for me the futility of management action. If this strategy were to change, then depending on the cost, I believe that there would be significant upside potential in Home Retail.

For the Argos retail format, sales fell 7.6% with like for like sales declined by 9% whilst operating profit fell 94% as the margin sharank to 20bps from 3% (ouch).

In terms of the Argos brand;

Total internet orders, including Check & Reserve grew to comprise 33% of Argos’ total sales, with the remaining 13% of multi-channel sales being products ordered in-store for home delivery or by telephone.

Despite 46% of sales being derived from online or telephone sources, the company opened 6 new locations compared with the same time last year. No while many customers order online or via the phone, they collect the requested item from the nearest store. I do not believe that this is justification for opening new stores. I would wonder what was the proximity of these stores to other Argos locations. Given the growth of the internet and phone channel, I would have thought this would have presented management with a rationale to close down many stores (particularly) in cities and towns with overlap, and move to a hub and spoke strategy or an expanded delivery startegy. Obviously the issue here is that many operating leases are costly to exit. In addition to expanding store count, the company has refurbished a further 50 stores. Now unless these stores were in abysmal condition I fail to understand the rationale here. The Argos format is one of catalogue ordering in a warehouse – it is not a place where consumers go to be pampered. If I were management I would be incentivising customers to order online and stay away from the physical stores.

Worryingly, the results from Homebase format (DIY stores) were also poor. While sales declined 1.8%, operating profit fell by 35%. I wonder is there a read across here for Grafton plc? 

Using trailing 12 month results, I calculate the following fixed charge cover;

EBITDA: £251.9m

Rent: £366m

Net Interest: £0.2m

EBITDAR/Fixed Charge Cover: 1.69x  (from 2x at the 12 month stage).

Net Debt (incl Leases)/EBITDAR: 4.7x (from 3.6x at the 12 month stage).

Given the state of the UK retail economy, it would be unsurprising to see 2nd half sales and earning to continue to slide – if this were to be the case, then fixed charge coverage would continue to slide. A glimmer of hope would be that between 2012 and 2016, there are 150 lease renewals and 35 lease breaks. This should give the management some leeway to resize the retail estate. (Pg 41. Interim Results presentation slides). On the conference call, management spoke of 10% on average rent reduction on present lease renewals.

In regards to operating leases, I noticed an interesting story in relation to builders merchanting group, Wolseley, on Bloomberg the other day. Wolseley has hired a lease breaking company to help extricate itself from several of its leased property estate.


Price/Sales is now 0.145 on a trailing 12 month basis. P/B is flattered by the presence of a significant amount of goodwill on the balance sheet. In its absence the P/tangible book value is 0.77.  The valuation is becoming more attractive.

If I take the present level of sales as being normalised, and then use an operating margin of 4% (as opposed to the historic median of 5.2%), then it is possible that the stock at 1000p trade on a P/E of 5x. There is an opportunity, but the balance sheet is in poor condition with Net Debt/EBITDAR now in excess of 4.2x.

As of now it is watch and wait. Management must accelerate lease restructuring in my opinion. Unless minimum fixed charge cover agreements are very generous, then the balance sheet is unlikley to survive until 2012-2016 in the absence of a recovery in the UK consumer. 


The recent collapse in the share price of Mothercare prompted me to pay a quick visit to the stock. Fascinating company, in that a large UK sales base is dwarfed in terms of profitability by a much smaller but faster growing international business. It is crying out for the dreaded sum of the parts approach to valuation. The CEO has recently stepped down having lead the company for much of the past 9 years.

Successful international expansion during 2009 and 2010 lead to the share price breaking out of the long term range between 300p-400p and trading up to almost 700p in late 2009/early 2010. Since then a succession of profit warnings has been met with hard selling and the stock now trades at sub 200p.

Key Metrics

P/S:  0.2

P/B:  0.95

G&D PE: 15

Fixed Charge Cover: 1.5

Net Debt(+leases)/EBITDAR: 5.9

Interestingly, in the past decade the company has been in a similar situation. During 2003, a spike in cost of good sold saw profitability and cashflow collapse. As a result Fixed charge cover fell below 1. The company survived that time.

UK Division

Revenue in the UK business has expanded from £414m in 2006 to £587m in the last annual report. Organic growth is significantly lower, in that Mothercare acquired the Early Learning Centre during the latter half of 2007, and that conributed to 37% top line growth in the follow year. UK margins have hovered between 3.8% and 6.7% betweeen 2006 and 2010. In the last fiscal year (ending March 2011) the UK margin has fallen to 1.9%. THe UK business is operated out of a predominantly leased store estate. The overall rent roll is £68m, which has fallen from £71m four years ago. Most of the rent roll relates to the UK business unit.

International Division

Presently, the international business is the jewel in the crown of Mothercare. Fast growth and high margins from far flung locations. The international business is asset light in that much of the renenue is redived from franchise operations. Sales have grown from £68m in 2006 to £206m in the last fiscal year. Margins have expanded annually from 7.8% in 2006 to 13.3% presently. The sceptic in me wonders how much further that margins can expand, however it would be curmudgeonly not to be impressed with the growth rates. The company has almost 900 stores in over 50 countries throughout the globe. Much of the expansion  recently has been in Asia and China. There are 11 stores in China and 62 in India. Some stores are operated on a JV basis and others on a franchise basis, where the franchisee pays a royalty to Mothercare. It is not clear at this stage of my analysis whether all of the revenue stems from franchise payments or is there a portio that is generated by underlying slaes and profitability of the franchisee. This would worry me, and requires more investigation.

Store Strategy

The company is attempting to ‘rightsize’ its store portfolio over the next 3 years. The company is in a fortunate position in that there are 90 operating lease expiries during the current fiscal year, followed by 30 next year. That equates to 1/3rd of the UK store portfolio.

It seems likely that these leases will not be renewed as the company has articulated a strategy for reducing its UK store portfolio by 107 stores over the next two years. Mothercare claims that,

In total, 150 stores will be affected with approximately 110 stores closed and rents renegotiated to a substantially lower level on a further 40 stores. We are in the fortunate position of having 120 lease expiries in the next two years, which is one-third of the entire estate, 90 in 2011/12 and 30 in 2012/13. The vast majority of these lease expiries fall within the lower profit in-town store estate. There are also 30 more stores which do not have a lease expiry and which we plan to exit with a cash cost. Total cash costs are expected to be less than £5 million, although this will depend on negotiations. The results of this activity will be to transform the UK estate by March 2013 reducing total store numbers from 373 to an estimated 266, 102 of which will be out-of-town Parenting Centres and 164 in-town.

On the company’s own estimates this will result in savings of £12m per annum in terms of rent payable, with total savings of £18m including rates and service costs. Not sure how realistic those savings are in light of the ongoing margin compression on the UK high street, but it gives me some comfort that unlike Home Retail group that there is an exit startegy.

Is there an opportunity?

On the basis that successful retailers (think Next plc or Inditex) trade on sales multiples of between 1.2 and 2.2 (as opposed to 0.2 at Mothercare), then optically there does indeed seem to be an opportunity.

I run the following simple sum of the parts calculation.

Sum of the Parts Intl UK  
Sales 239.4 557.8  
Margin 12% 0%  
Operating Result 29.9 5.6  
Central Costs -4 -3.5  
Savings store closures   3  
Cash EBIT 25.9 5.1  
Interest Costs -2.00 1.00  
JV Costs -2.4 0  
Pre Tax Profit 21.5 6.1  
Tax @ 28% -6.0 -1.7  
Net profit 15.50 4.38  
NAV (including central liabillities) 84 88  
RoNAV 18.5% 5.0%  
Sum of Parts      
Revenue Multiple 1 0.15  
Implied Valuation 239.4 83.7 323.1
Current Market Cap     167.316
Theoretical Upside     93%


 I chose a 1x revenue multiple for the International division as it seemed appropriate when comparing the unit to other high margin European retailers (many on multiples of 1-2.8x). The 0.15 multiple for the UK unit is reflective of the situation that many UK retail chains find themselves in at present.

I have no idea as to how realistic a valuation this is, it is a first stab in the dark. However it is sufficient that I am now interested in investing in Mothercare. Before I do that I will look for reasons where I maybe wrong on the valuation of the international business. It is afterall a franchise business, and this does involve some loss of control. I need to get behind as to how revenue is actually earned in this unit, and how stable it is.



I note that I was fellow blogger Expecting Value, beat me to the punch in terms of publication yesterday. You can read his post on Mothercare here.




John McElligott


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