Category: Equities analysis

Give me my money back!

Two weeks ago, shopping centre owner Vicinity announced it would buy back up to 5% of its stock on market after it delivered its full-year results on August 15. This delivered investors an immediate 5% bounce in the trust’s share price, as the market anticipated over $500 million of Vicinity’s stock being repurchased over the next 12 months.

In this week’s piece, we are going to look at share buy-backs and why they generally have a positive influence on a company’s share price. However, buy-backs are not always positive. Next week in the second part of our deeper dive into buy-backs, we will analyse the bad buy-backs and the cheapest ones of all to execute: the fake buy-backs that create the illusion of share price support.

Buy-backs are almost universally popular with investors as they not only reduce the number of shares outstanding by which to divide a company’s profit, but they return certain capital to investors today, rather than waiting for an uncertain return tomorrow. This is important, in light of the numerous occasions where company management teams have frittered away excess cash on questionable acquisitions or hastily conceived expansion plans designed to buy growth or move into new markets.

Types of buy-backs

There are essentially two ways that a company can repurchase or buy-back its shares. They can do it on-market using a stock broker, or off-market by inviting shareholders to tender their shares for repurchase. Off-market buy backs are generally done by companies such as BHP that have large balances of franking credits, as the buy-back can be structured in a tax-effective manner for domestic investors by returning a combination of cash and tax credits. Companies such as CSL that earn the bulk of their profits offshore are more likely to buy back their shares directly from investors on the ASX as they don’t have excess franking credits.
Occasionally companies will limit the buy-back to a particular investor, though this is usually very poorly received by the wider investor base. The last company that tried to do this was Woodside in 2014 when it offered the equivalent of $48 per share to buy back$2.7 billion in shares from Shell. This failed to get shareholder approval and with the share price currently around $29, it was clearly the right move for shareholders to block this move. Currently Rio Tinto is conducting an on-market buy-back that is limited to the company’s London listed shares. This selective buy-back is being done to close the price discount at which Rio’s shares trade on the London exchange compared with the price in Australia.

Why investors like buy-backs
Signal that future prospects are good

Buy-backs signal to the markets that a company’s management has strong confidence in the future financial prospects of the company, as the company is returning what it sees as excess capital to shareholders. A weak company in a weak financial position, with nervous lenders raising concerns about the repayment of debts due is extremely unlikely to be returning capital to shareholders. As raising new capital is both time consuming and expensive (fees going to investment bankers in sharp suits), if a management team has some concerns about the outlook, they will retain excess capital on their balance sheet.

Change in capital structure

By returning cash to shareholders, the buy-back alters the capital structure of a company, by increasing the proportion of debt on its balance sheet used to fund its activities. Similarly, it increases the financial leverage or net gearing by reducing the cash component in the denominator of the below calculation.
Net Gearing = (Total Debt – Cash) / Book Value of Equity
If the company is “under-geared”, repurchasing of shares increases leverage. In the case of shopping centre owner Vicinity, due to the $1.5 billion in asset sales sold over the past 18 months, the trust’s gearing decreased to 24.7%. Buying back stock below net tangible assets (NTA) is not only earnings accretive, but it organically increases financial leverage and thus the equity owner’s share of rising profits.

Reduces the chance of poor acquisitions

A buy-back also provides investors with comfort that excess cash is not just being retained for empire building, possibly to be squandered on bad investments which tend to be made by companies in cyclical industries at their peak. A great example of this was Rio Tinto’s purchase of Canada’s Alcan in 2007, which not only drained the company of the excess capital built up by the mining boom, but resulted in an ignominious and highly dilutive rights issue in 2009.

Scares off short sellers

Buy-backs tend to cause share prices to trade upwards, as the companies’ buying puts upwards pressure on shares. When buying back shares, companies are required to file a new notice after each day when they buy shares. This notice is posted on the ASX for investors to see and details the number of shares bought and the price paid.

This may cause short sellers to close their short positions in a company conducting a buy-back (also causing upward price pressure), as they know that there will be a new buyer consistently purchasing shares in a company in which they have a short interest. Further, a company is likely to step up that program and increase buying on any share price weakness.

When I was working at a US investment bank writing research on building materials company James Hardie, I was able to observe the wave of buying from short sellers of James Hardie on the morning that the company announced a share buy-back. This pushed the share price higher than the announcement actually warranted.

Our Take

Returning excess capital to investors as distributions rather than retaining it reduces the capacity for management teams (acting as investors’ agents) to expend capital in ways that might not be in the best interests of investors. Where excess capital is returned to investors in the form of distributions and buy-backs, this excess capital sits in investors’ bank accounts rather than the company’s. If management want additional equity for an acquisition they are then required to make an investment case to their investors. We are expecting the announcements of a few buy-backs over the next few weeks, especially in the Listed Property space from trusts that are able to buy back their own shares that are trading below net tangible assets per share.

The biggest IPO of all Time

Since mid-June the oil price is up 15%, which has breathed fresh hope into beleaguered energy companies globally.  The catalyst for the recovery in the oil price was the announcement that Saudi Arabia, OPEC’s largest producer, will limit exports to 6.6 million barrels a day in August, 1 million lower than production this time last year.  This has been interpreted as rational profit maximising behaviour by the world’s largest producer, which has traditionally sought to defend market share and maximise oil revenues to prop up the Kingdom’s budget.

We see this as behaviour designed to boost the profit margins temporarily, similar to what is done by many vendors prior to any IPO.  In early 2018 the Saudi’s are looking to conduct an initial public offering (IPO) of around 5% of energy giant Saudi Aramco for a predicted price of US$100 billion. In this week’s piece, we are going to look at how to analyse IPOs and specifically this one, which is likely to be the biggest IPO of all time.

When analysing IPOs, few have been more eloquent on this subject than Benjamin Graham, the Father of Value Investing;

“Our recommendation is that all investors should be wary of new issues – which usually mean, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under ‘favorable market conditions’ – which means favorable for the sellers and consequently less favorable for the buyer.” (The Intelligent Investor 1949 edition, p.80)

The biggest IPO in history

Last January the Saudi Arabian Crown Prince Mohammad bin Salman Al Saud announced that the Saudi government intends to offer shares representing about 5% of Saudi Aramco, its national oil company. Aramco has been under government control since the Saudi Arabian Oil Company was nationalised nationalized in the 1974 following US support for Israel in the Yom Kippur War.

Aramco is the largest global oil producer and therefore this IPO marks a shift in thinking in the Kingdom as the proceeds are being used to help diversify the economy away from oil. The IPO is planned to be listed on exchanges in Riyadh, with a secondary listing in London, New York, Hong Kong or Singapore. The expected value of 5% being floated in 2018 is touted as around US$100 billion which would value the entire company around US$2 trillion. This is significantly larger than Apple (US$742 billion), Google (US$653 billion) or Exxon Mobil ($342 billion). Under these circumstances the Saudi’s have a very strong incentive to move the oil price higher over the next 9 months!

Factors to look at in an IPO

Why is the vendor selling?

The motivation behind the IPO is one of the first things we consider. Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business. An example of this is Orica and their paints division Dulux. New investors also tend to do well when the vendors are using the proceeds to expand their business. The probability of new investors doing well from an IPO is far lower when the seller is just looking to maximise their exit price. A classic example of this is the Myer IPO. In the case of Aramco, the IPO is designed to help makes changes to the Saudi economy and increase investments in non-oil assets. Cynically it could be viewed that the vendor is concerned about the longer-term demand for oil with increasing amounts of Teslas roaming the streets, though only 5% is being floated off at this stage.

Is the business easily understood?

Given the reduced level of historical financial data it is important that an investor can easily understand how the company makes money and maintains competitive advantage. When Shopping Centres Australasia was listed in November 2012, it was clear how the company made money from collecting rents on Woolworths’ shopping centres. Similarly, in the case of the best float of 2015 (+127% since listing) it was easy to understand the Costa Group’s business model of growing mushrooms, berries, citrus and tomatoes with the logistics operations to deliver these to consumers.

Whilst the Aramco business of extracting oil easy to understand, like most IPOs the financial data may be limited. The secretive company has never needed to disclose any kind of financial statements and details about the company’s most important asset, its oil reserves are state secrets.

Is the company profitable?

Any IPO is presented to the market in the most favourable light (albeit with a large number of disclaimers), and at a time of the seller’s choosing. Over the last six months we have seen a number of businesses being listed that have been unprofitable for a number of years, yet are expected to switch into profitability in the years immediately after the IPO. We put little store in the notion that companies are being listed for the altruistic benefit of new investors. Thus, investors should be sceptical of predictions of dramatic improvements after listing, especially when the IPO vendors have significant incentives to show profits before listing!

Saudi Aramco is likely to be very profitable with international energy consultant estimating costs of production around US$9 per barrel. The cost of production is so cheap as the oil in Saudi is primarily located near the surface of the desert and pooled in vast fields, so unlike Australia it doesn’t need to invest very expensive offshore oil platforms taping into reserves often 100kms off the coast.

The question for minority investors is the extent to which this enormous company will be run in the interests of the minority investors committing $100 billion or whether profits may be diverted to the state.  Two months ago, the Crown Prince said that decisions about oil and gas production and investment will remain in the hands of the Saudi government after the IPO.  In March 2017 in what looks like a move to improve the books prior to the IPO, the Saudi government reduced the tax rate levied on Aramco from 85% to 50%. Investors in this IPO would probably be concerned that this tax rate could change post-IPO to fund government budget deficits given that Aramco currently accounts for 80% of the Kingdom’s budget revenue.

Is the price attractive?

The sole reason behind any new investment is the view that it will generate a higher rate of return than alternative options in an investor’s portfolio.  It is too early to make any pronouncements as the financials have not been released, but any investment would want to take a conservative long-term oil price into account and discount stronger oil prices that we may see over the next nine months.

Despite what is contained in the marketing documents for every IPO, in determining a valuation potential investor should apply a discount to currently listed companies. Due to an IPO lacking a listed track record and investors having less financial data; a discount to currently-listed comparable companies should be applied when valuing an IPO. In the case of Aramco, in our opinion the price investors should pay would be a 20% discount or greater to valuations at which companies such as Exxon Mobil, Chevron or Shell are trading at.

Our Take

Whilst new IPOs are presented as fresh, exciting ways for investors to make money and access different high growth companies or assets, we see that the best approach to evaluating IPOs is to start from the default position that the vendors are trying to cheat you and then work backwards from there.  The best IPOs I have seen over the past 20 years have been one’s where the vendor is under-pricing the asset being sold, leaving some upside or “margin of safety” for the new investors.

Understandably this is a very rare occurrence for profit-maximising private equity owners and possibly Middle Eastern Kingdoms.  The Saudi government (just like private equity vendors) may face some domestic backlash for pricing the IPO too low if Aramco performs strongly post listing!

 

Not all Great Ideas turn into Great Companies

In my experience, most professional fund managers and equity analysts are frequently given unsolicited stock ideas from clients and friends. Generally, these are small companies, with a great idea that is either going to turn them into the next Amazon or revolutionise a particular industry.  Frequently these companies are difficult for investment professionals to value as they are often at a very early stage. They tend to be long on promise, but short on profits and assets that provide the basis of most valuation methodologies. Inevitably the person presenting the idea knows much more about the exciting technology behind the company and is very enthusiastic about its prospects.

In this week’s piece, we are going to look at the processes and questions that investors should ask when looking at early-stage listed companies.  Atlas is not endorsing any of the companies mentioned in this piece, they are only mentioned in the context of the process that we use in evaluating early-stage companies.

1. How much runway do management have?

The first thing that I look at when reviewing one of these speculative companies is how much time or financial runway management has in which to commercialise their idea before running out of cash. Whilst companies can look to raise additional equity to extend this runway, this is almost always done at a discount to the prevailing share price and relies on supportive investors. Few early-stage companies are financed by debt, as the interest rates charged are likely to be high to compensate for the risk of lending to an unprofitable company.

Investors should look at the company’s cash flow statement to gauge how much cash the company has been burning for the past six months. Compare this against how much cash is on hand on the balance sheet. The reason for using the cash flow statement is that this represents actual cash flows and is harder to manipulate than the profit and loss statement. For example, when I looked at cloud call recording software company Dubber in February, the company reported a cash burn of $4M in the previous six months, yet had $5.2M cash on hand. Here unless there is a dramatic change in the company’s fortunes, one could expect another equity raising within the next 9 months.

Conversely, technology company Fastbrick Robotics had no debt and $10M of cash on hand. This is sufficient to fund the company’s development of a bricklaying robot beyond 2019. Without making any judgement as to the relative investment merits of the two companies, the second company has more flexibility to weather delays, without coming to the market to raise more equity to keep afloat. Obviously, the spectre of near-term equity raisings provides a cap on a company’s share price, as outside investors know there will be discounted share issues in the future.

In more extreme circumstances, the lack of a financial runway has seen companies with solid ideas or assets going into administration, with these assets later picked up by competitors.

2. Management’s record and shareholding

The next step is to look at the experience of management and board of the company in question.  Here what I am looking for is not so much experience at large and well-known corporations such as General Electric or Westpac, but rather experiences in guiding small and more financially unstable companies through to an IPO or trade sale. Large companies have little difficulty in getting attention from potential investors or banks and managing cash flows. Additionally, executives from large organisations are unlikely to have had experience of running a number of business areas while also having a laser-like control of costs.  Looking at job management software GeoOp, it was apparent that the chairman and CEO have solid experience in the digital space and in running start-up ventures.

Additionally, investors should look at the percentage of the company owned by management, as a management team with a significant portion of their personal wealth invested in the company are more likely to act as good agents on behalf of the other shareholders. Here investors should look at existing holdings, as well as the share options granted when management hit certain targets such as profitability and specific share prices.

3. Who else is on the share register?

The presence of larger corporations or well-regarded fund managers on a fledgling company’s share register should be viewed as a good sign. This can indicate that others have done the due diligence on the company, and it is often helpful that they have the voting firepower to stand up to management and scrutinise decisions. The presence of competitors or corporations in similar industries could indicate the possibility of a takeover at a later stage. In the Dubber example mentioned above, the presence of small capitalisation manager Thorney on the share register at 6.4% is a positive sign.

However, the presence of well-known fund managers on the register should not by itself be viewed as sufficient grounds for investment.  Most if not all small capitalisation fund managers have positions in their fund that they now regret and may be quite illiquid at the size of their investment. What may seem to be a significant investment for an individual investor may only represent 0.25% of a large fund.

4. Who are the Company’s competition and what is the size of its addressable market?

All successful small companies face the spectre of competition from large industry players. In some cases, large competitors may be watching the target company closely, learning from their mistakes, before launching a competing product or technology drawing on the larger company’s scale and market access.  Whilst “disruptive” financial technology companies or fintechs are very much flavour of the month at the moment, I find it hard to believe that the big banks and insurance companies are not keeping a close watch their activities. A great example of this is mobile payments company Mint Payments which in 2013 went from 2c to 40c per share on expectations that the company’s wireless point of sale would enjoy spectacular growth. The share price has slid back to 6c as the banks and technology companies such Apple launched competing payment products.

When looking at the prospects for a company and its potential growth, it is important to look at the size of the market to which its products can be sold. A small niche market might not attract competition from larger players, but significant share price growth is unlikely to come from dominating a very small market. Additionally, investors should be wary when a company suggests that it has no competitors, often this is a case of no competitors yet.

5. What barriers to entry are there?

A small company’s prospects of enjoying significant share price gains are significantly decreased if there is little in the way of barriers to stop other firms from entering into their industry. The technology sector in particular has been an elephant’s graveyard of large companies laid low by smaller, more nimble competitors that jumped over the low barriers to entry.  Examples of once exciting companies that only had low barriers to entry include AltaVista, Netscape and Myspace.

Recently we looked at social media marketing company VAMP that was planning on listing on the ASX and was backed by high profile Nova Scotian Qantas and Fairfax Media director Todd Sampson. The social media marketing firm had an exciting buzz as it was designed to capitalise on growing demand from advertising agencies and high-profile consumer brands to connect with Instagram ‘influencers’. However, on reflection, this particular antediluvian fund manager thought that the barriers to entry into social media marketing are quite low.

Our Take

Whilst most small companies have an exciting good, technology or concept that is inevitably presented in a form that will result in large gains in the share price, we see that it is helpful for investors to have a five-point checklist to look at when evaluating a small, exciting, yet unprofitable company. Atlas would like to thank our supporters whose ideas helped in writing this article.

Themes emerging from reporting season

This week saw the end of reporting season for 180 of the S&P/ASX200 companies and around 2,000 of the companies listed on the ASX. Over the past month these companies revealed their profit results for the last six months and provided guidance as to how they expect their businesses to perform in the upcoming year. Whilst we regularly meet with companies between reporting periods to gauge how their businesses are performing, during semi-annual reporting season companies fully open up their car bonnets to let investors have a detailed look at the their financials. Until this happens, investors don’t know for certain whether they are going to find burning oil and hissing pythons or see that the company’s growth engine is running to expectations.

We previously looked at what happens behind the scenes in reporting season and in this week’s piece we are going to run through the key themes that have emerged over the last four weeks.

Surprising strength

The February 2017 reporting season was on average benign for investors was generally better than expected due to strong earnings growth from the miners (BHP and Rio Tinto), banks (Commonwealth and ANZ) and healthcare (CSL). Earnings growth in these sectors offset weakness in profit in the industrial sector.  Overall we have seen approximately 18% growth in earnings over the 2016 financial year, though the bulk of this is due to the resource companies enjoying the benefit of resurgent commodity prices. Excluding the resources companies, earnings per share from Australian companies in aggregate climbed by +6% over the past year.

Rock diggers looking good
The market was expecting the miners to do well as commodity prices – namely coal and iron ore –  had received a boost. This was largely due to a Chinese stimulus plan in 2016 based on rapid rise in fixed asset investment in infrastructure, reducing real estate taxes and loosening lending standards. What surprised us was the commitment among the miners to controlling production costs, reducing debt and keeping a lid on capital expenditure. This allowed BHP to report a 65% increase in profits and a 150% increase in the dividend (that had been savagely cut in February 2016).  Rio Tinto paid off US$4.2 billion of debt and announced a share buy-back.

On the conference calls to investors, management teams promised to maintain capital discipline and not waste the windfall of temporarily higher commodity prices. I am hopeful that before I retire from the funds management industry sometime around 2050, I will have seen a commodities boom where shareholders capital in mining companies was not frittered away on questionable acquisitions and marginal projects at the top of the market!

Banks squeezing their pound of flesh

Whilst the banks and financials stocks performed well in the last quarter of 2016, January saw a significant sell off in their share prices of around -5% as investors became concerned about the impact of rising interest rates.  Commonwealth Bank reported cash profits of $4.9 billion, which was higher than expected due to cost controls and keeping loan impairment expense flat at 0.17%. Similarly ANZ reported that revenues were up +7% and there were minimal loan losses.  NAB reported a 1% fall in quarterly profits but echoed the other banks’ views on low loan losses.  We see that the banks are well placed to have a good 2017 as the repricing of their loan books will drive revenue growth.

Give me my money back!

Capital management was a feature of the recent reporting season and was understandably popular with investors. Rio Tinto, CSL, Coca-Cola and even QBE Insurance announced share buy-back plans. In the case of QBE Insurance we found it hard to get excited about their A$500 million buy-back given that they conducted a A$780 million capital raising 2.5 years ago at a price that was a 15% discount to the current share price.

At a dividend level AGL Energy, Transurban, Rio Tinto, GPT and Bluescope Steel all increased dividends to shareholders that were above market expectations. Across the market the dividend pay-out ratio remains high and is now approaching 80%. Increasing dividends and buying back stock boosts share prices in the short term  and plays to the current “search for yield” investment theme. However, in the longer term companies do need to retain cash to reinvest in their operations in order to grow.

Best and worst results

Over the month, the best results were delivered by Transurban, Rio Tinto, QBE Insurance, CSL, Boral, ANZ Bank, Invocare, Treasury Wine Estates and AGL Energy. The common theme amongst these companies was a solid control of costs and a profit result that did not rely on an improvement in the domestic Australian economy. Woolworths’ share price performed well after they announced sales growth that was ahead of Coles for the first time since 2009. However, shareholders paid for this market-share gain in the form of lower prices, which caused profits in food business to fall by $131 million to $811 million.

On the negative side of the ledger Blackmores, Genworth, James Hardie, Brambles, Domino’s Pizza and Primary Healthcare all reported disappointing results compared with other companies. The common themes among this group was high price-to-earnings rated companies not delivering on high expectations, or companies that had downgraded expectations and hence delivered results that were worse than expected. Telstra had a particularly tough reporting season with profits down -14%, but what concerned the market was the fall in mobile revenue and evidence of more intense competition.

Our take

In contrast to other reporting seasons, this one was relatively benevolent for quality-style investors avoiding both high priced growth stocks and companies with issues. After overall market earnings declines in 2015 and 2016, this reporting season provided evidence that company profits are rising again and that profit margins (ex financials and resources) are rebuilding. This positive view of the Australian economy was confirmed by the ABS GDP data released yesterday that revealed the Australian economy grew by +1.1% in the December quarter and by +2.4% in 2016, which was well above consensus forecasts and the strongest growth in four years. Whilst we expect the banking sector to have a solid 2017, commodity prices (which we expect to weaken) should dampen earnings for the remainder of the year.