Investment research into UK Stocks by Walbrock Research

[Walbrock Research]

A look in the life of individual stocks of UK-Listed companies. So, stay tune.

 

[Walbrock Research]

Can RIGHTMOVE PLC (LSE: RMV) gives us clues in looking for great businesses?

Rightmove's business model is successful as long as they see rising house prices in the UK. And that has been the case in the past eight years. Since then, RIGHTMOVE was able to:

1. Raise advertising fees from £117pcm in 2004 to £830pcm today, an annual compound rate of 17.7%. Meanwhile, UK House prices compounded at 3.9%/annum, or a total of 58% in that same period.

2. Cash operating margins increase to 60% from 30%, a decade ago.

3. It accounts for 70% of the UK property internet portal driving 11.7bn visits with visitors spending 1bn minutes per month on their website.

The Economics of RIGHTMOVE (and ZOOPLA)

A typical fee one estate agent makes is between 1% and 3% of the property value sold. So, typically a property value of £250,000 gives the estate agent’s £2,500 to £7,500 in fees. I can hear the thoughts on your mind telling me this:
£842/month multiply by 12 = £10,104 of fees to RIGHTMOVE.
Remember, property transaction is a volume business. The UK does over 100,000 property transaction per month, or over 1.2m transactions per year, also there are 157,000 estate agents. So, one estate agent (on average) sells 7 or 8 properties per year. In total, an estate agent makes around £17,500 to £52,500 in properties transaction.

If you want to know more, please go to my website.

 

[Walbrock Research]

Carpetright PLC to target £4/share soon

Management attitude of conserving cash and refreshing stores’ format is the right strategy for the turnaround of its business. Also, I get the sense Carpetright wants to emulate WH Smith by focusing on margins improvement while stemming the decline in sales.

However, the share price of Carpetright PLC seemed less enthusiastic, despite the return to profits (making £14m per annum) and reduction of debt (£7m in borrowings from £105m, six years ago).

The interesting thing is the current market valuation of £140m is 85% below peak valuation of £1bn. And, profits are growing from the refreshing their stores' format.

Recently, Carpetright plc shares gone up by 25% in two weeks with the monthly chart telling me a £4/target is next. http://bit.ly/2mFdRyQ

P.S. I researched this a few weeks ago and written an article on my blog.

 

[Walbrock Research]

Dialight valuation ahead of fundamentals?

Dialight (DIA) saw market valuation reached £350m or 440% higher in 15 years.
But, what about its fundamentals?

The business saw no growth in sales (+4%) with declining earnings of 78%. One positive spot is free cash flow increasing by 55%.

However, fundamentals have not catch-up market valuation. The only explanation is the stock market is overheating sending any shares to the moon.

P.S.: The dot-com bubble didn't end well for the shareholders back in 2000.

 

[Walbrock Research]

Jd sports given shareholders 1,500% gains

JD Sports is one of the most successful companies in the last decade with share price gains of 1,584%!

These factors contribute to the following gains:
1. RISING PROFITS AND INCREASING MARGINS; - Profits grew from £8m to £133m in 12 years, whereas margins rose from 1.5% to 7%.
2. Revenue growth grew at a compound rate of 12.2% per year.
3. The value placed on JD Sports is close to 40X earnings and EV/EBIT of 25X (a record).
4. For every BRITISH POUND spent, JD manages to produce an extra £2.45 in sales within one year of implementing capex.
5. JD Sports has a net cash position of over £112m.

The funny thing is the previous decade (1996 to 2006) saw shareholders lose 8% on the stock.

 

[Walbrock Research]

Is Molins a value play?

Maturing business Molins is struggling to grow.

Revenue is 33% smaller today, then 2004. Market valuation decline by 80% since 2003. Are Molins shares still value for money?

Molins management made a recent trading update suggesting the poor results is for last year. Because customers were delaying orders till 2017.

The second good news is their pension situation. With the UK Bond Rates (known as the 10-year Gilts) rising. Their assets pay more in cash flow to Molins retirees.

The downside to Molins is capital expenditure. Because they haven’t spent big for a long time. Molins asset age in 14 years (is a record), and 60% of their assets meet that age.
Their last big spend was in 2003 at £13.6m. Since 2009, Molins average £4m in CAPEX. Don’t be surprised if they spend £10m.

On share price, Molins could average 80 pence per share in 18 months. But, don’t be surprised if it falls back to 40 pence because of the markets at all-time highs.

 

[Walbrock Research]

St. Ives plc

Here are some facts about this company you need to know (not in any particular order):
-Net book value of freehold drops from £55.3m to £13.3m in 16 years.
-It has 160 clients on their books compared with 130 last year.
-Revenue in the early 2000s is higher than today.
-Profits are very volatile.
-The business disposed of assets worth £500m since 2002.
-Today, property, plants and equipment drop from £200m to £30m in 15 years.
-The weekly technical chart shows a strong buy signal. http://i.imgur.com/APja03L.png
-The capital turnover ratio is an early indicator for investors to sell if valuation got too frothy.
- The depreciation and amortisation charge since 2002 is £341m.
-Since 2002, total gross capex spending came to £477m with net capex amounts to £136m.
-As well as doing a lot of disposing (£500m worth in 14 years), they did a lot of acquisitions causing goodwill to go from £41m to £189m (2016).


- In the last 14 years, there have been 15 occasions where the share price movement were greater than 20% in either direction.
-If 2017 is another loss-making year, it will be the second time in a row.
-The last time it made a net loss (in 2009), market valuation (such as P/B and P/S) is 70% cheaper than today, despite share price collapsing. You can argue we are in a bull market which helps St. Ives to keep a hefty valuation.

 

[Walbrock Research]

Tasty PLC, a value restaurant chain?

I like this business because management has a record of past success in the industry.
Below are some key findings:
1. Annual lease per restaurant is £88k, down from £110k seven years ago.
2. The leasing duration for each chain is roughly 16.7 years. It worked out as annual lease/total operating lease = 6%. So, (1/6% = 16.7)
3. Asset turnover minus cash is stable.
4. External funding since IPO’s admission totals £32m or £3.2m per year.
5. Market valuation is at a three-year low.
6. As management revise that new store openings to seven, it helps reduce capex down to around £6m. Previous guidance of 15 new stores would result in £13m to £14m capex.

Industry Outlook

The Guardian posted a piece stating an accountancy firm cite 5,570 restaurants has a 30% probability of going bust in the next three years.
These contributing reasons are: -
-The UK imports 48% of its food, this leads to higher operating costs;
-The cost of labour is rising from £6.70 to £7.20 in April, with a further rise to £7.50 to take place next April;
-More consumers are in debt; - 48% of borrowers have a credit card which is not cleared in full each month, compared with 39% a year ago.
Although they were valid points, we don’t know how many of them are restaurant goers?

 

[Walbrock Research]

For those interested in Tullow Oil

Here are my findings.

(P.S. All data got converted back to British Pounds.)

The company has been through a rough three-year patch that saw long-term shareholders lost all capital appreciation dating back to 2006!
Recently, Tullow Oil asked its shareholders to fork out $750m in a Rights Issue at a discount of £1.30/share.
Is this the turning point for Tullow and a change in fortune for its shareholders?
First, Tullow’s shares didn’t initially fall because of collapsing oil price. It fell because operating profits collapsed to £245m in 2013 from £700m, along with large capex spending in the future.
But declining oil price did exacerbate the shares lower by another 60% from £6-£7 per share.

To explain my answers in a concise and clear answer I want to dissect Tullow Oil into two sections:
1. Operational;
2. External.

Operational

(Period discussed is from 2006): -

A. Tullow Oil spends £9.6bn in finding the replacement of oil sold and building up its reserves.
That resulted in oil reserves & resources increasing by 686m to 1,193m. Given that Tullow sold 243m over this period, then the capital spend per barrel is £9.6bn ($14bn) divided by 929m = $15 per barrel.
The $15 per barrel capex doesn’t include the operational costs of extracting the oil on an annual basis. Add in operational costs per barrel, the cost of oil totals $71.9 per barrel in 2016.

B. Despite the big spend, sales volume of oil increased by 2,600 bopd, a 5% growth.
C. Despite years of producing oil, Tullow Oil has rarely generated positive free cash flow. In fact, it lost a total of £4.4bn. http://i.imgur.com/CDqwZd8.jpg (Data from Tullow Oil annual report)
D. Last year, oil production came to 71,700 bopd in 2016. A year ago, it gave a production for 2016 of between 78,000 to 87,000 bopd, a 10%-24% miss.
One big reason is down to its Jubilee field in Ghana. That oil field contributes around 26,000 bopd to Tullow Oil (or, around 35% of total oil production).
E. With this year oil production guidance of 88,000 bopd, it already downgraded this by 5,000 bopd.
F. As mentioned earlier, the level of total debt grew from £214m to £4bn, while sales doubled.

External Factors
Now, for the external factor, mainly the role of WTI/Brent Oil.

(Unless stated this period is from 2011)

The collapse in oil price has affected Tullow Oil business in the following ways:
A. Tullow generated sales of 25 pence for every pound it holds in assets. Now, it does 10 pence.
B. With capital turnover, Tullow is returning less than half of its investment.
C. Net cash earnings fell to £417m from a peak of £1.1bn.
D. Tullow, also written-off impairment charges totalling £5bn.
E. In 2016, half the oil was hedge at $75 per barrel, this enables the firm not to experience the full impact of adverse oil prices. Today, it can only get $60 per barrel for 45% of oil production.

For 2017

Reasons to be optimistic are: -

A. Capex spending cut to $500m this year, down from $900m last year.
B. Hopefully, it could achieve higher oil production of at least 80,000 bopd.
C. OPEC oil production cut to maintain oil prices.

Reasons to be pessimistic are: -

A. This year oil hedge is 20% lower than 2016, it puts pressure on margins.
B. U.S. oil production dampening price increase. http://i.imgur.com/mBwWRh3.png

C. Further operational production disruption possible.
D. The North Korean crisis looking likely as both sides won’t back down. That would dampen trade and economic activities.
E. New share outstanding of 1.38m values Tullow at £3bn. It would limit any gains in the share price.

 

[Walbrock Research]

1Spatial, a business for employees

1Spatial is a phoenix rising from the ashes with its extraordinary sales growth. But the problem is it never made a penny in profit for shareholders.
One obvious reason with most “techies” is the cost of hiring to find talent proves expensive. Although I regard the firm ability to find new businesses, it’s an employee-base business.
Think of Premier League Football where the players get all the dough, but leaves the club (vis-à-vis Billionaires owners) with the losses.

 

[Walbrock Research]

Kainos Group a software firm you can trust?

Kainos Group has been listed on the market for two years at £1.35 per share. Now trading around £2.60 per share. The listing has made 9 millionaires for the owners and senior managers.

Looking towards their next report (end of May), they haven't given much detail away (apart from saying they are trading in-line with expectations), but might have let something in their latest trading update. That is Kainos has recruited 216 new staff since April 2016, which is a 25% increase. From my research, I have evaluated the revenue per staff growing from £81k to £104k in three years. Similarly, profit per staff rose from £10k to £19k.
So, using conservative estimates of £105,000 sales per staff and £20k profit per staff, then my forecast for Kainos Group’s 2017 is:
A. An approximate revenue of £102m from £76.6m;
B. And operating profit close to £20m from £14.2m.
These are impressive estimates and we will see by the end of this month.

 

[Tendong3]

Thanks for sharing. I even didn't heard about this firm before.

 

[Walbrock Research]

What you need to know about PayPoint ahead of tomorrow results

PayPoint PLC results coming out tomorrow and here are a few things I have learned from the company: -

1. Apart from last year, PayPoint has made ROCE of 40% plus in the last decade;

2. It consistently generates more cash profits than accounting profits. Over a 10-year period, this averages 26% higher;

3. Since 2005, its dividends payments totalled £182m is fully covered by free cash flow generation £255m;

4. The disposal of its online and mobile payment services raised £40m. At the same time, it is upgrading their Epos platform for the first time in 12 years.
It means PayPoint would need to invest substantial amounts of money for manufacturing because there are no upfront payment costs if retail agents were to upgrade their PayPoint system. Instead, there would be a milestone payment of £20 per week for the next two years.

Source: https://www.conveniencestore.co.uk/news/paypoint-one-rolls-out-to-convenience-sector/542730.article

Analysts are expecting 63 pence per share earnings, this gives a forward-PE of 15 times.

 

[Walbrock Research]

The Good, The Bad and The Ugly of WH Smiths

The post is originally from walbrockresearch.com/home and I have full authority to re-post as I am the author. All images links are charts I've created and helps to interpret the text.

Sometimes if you want to pick the right stock for your portfolio, then you need to study successful companies that deliver to shareholders. One company that has delivered is WH Smiths. Now, we need to dissect the key drivers that drove WH Smiths share price to record highs.

N.B.: This post isn’t recommending WH Smiths shares, but it is an education.

How did WH Smiths defy the odds

WH Smiths is one of the oldest businesses in the UK (Founded in the 18th Century). Having survived the financial crisis, it makes hay and grew from strength to strength.

Trading profits from both divisions grew by £87m in eleven years. One huge factor is due to winding down its high-street division (or, so we believed).

http://i.imgur.com/5dERMhp.jpg

WH Smiths has drastically cut down their high-street division as sales collapsed from £1,112m to £639m, a near 50% drop.

Lesson: - When you see declining revenue, don’t assume the business is bad.

Always look at their gross and operating margins.
Their travel division has doubled in sales, with profits more than tripling. This is because more people are travelling via rails and planes.

The rebirth of British Rail

The growth of air travel

Okay, we know the basics on how WH Smiths have turned around their business. Now, we turn our attention to the details of their financials and operations.

WH Smiths Good Points

Increasing Profitability

One key attribute behind WH Smiths increasing operating margins have been their ability to reduce external costs. Increasing Gross Margins has helped Smiths to improve operating margins by 3-fold. That’s despite rising rental expenses and staff costs.

Able to pay higher wages

Talking about staff costs, you would think the National Living Wage would pose a threat by increasing their operational expenses. So far, Smiths was able to raise average wages from £10,600 to £14,700. You might think this is still low for annual pay, but, you have to take into account the part-timers, under 21s, etc. Those working part-time could be earning £7k per annum (I’m guessing here). Meanwhile, you have store managers and high ranking staff members who are paid higher salaries, which helped to lift the average cost per employee.

One helpful factor is Smiths was able to keep up with the times and cut staff numbers.

Since 2005, Smiths has cut their workforce by 28% and that has given the company an ability to meet minimum pay increases. Also, it manages to help boost revenue productivity per worker.

That saw an increase from £75.5k in 2005 to £88.4k in 2016.

How was WH Smiths able to achieve these efficiencies gains?

The obvious reason was to assume closure from loss-making stores in their high-street division (refer to the big falls in revenue). The other reason is the increased use of self-service checkouts. You can also point to factors like low inflation and closure of several competitors like Woolworths. Then there is the sales boost from their “busier” travel division.

A Stagnating Business requires less Capital Spending

A look at free cash flow would tell you if a business is spending “crazy” amounts of money or spending enough to maintain their assets.

In WH Smiths case, free cash flow is producing high cash inflows numbers. On average, it accounts for 70% of operating cash flow. And this shows in the capex/depreciation ratio (%). Since 2005, maintenance (depreciation) amounted to £439m vs. capex’s £422m, that’s 96% maintenance coverage!

This gel well when you compare it to the change in sales from £1.423bn to £1.212bn in the same period, a shrinkage of 13%.

Knowing How to Reward its Shareholders

Whatever you think of WH Smiths, the retailer knows how to reward their shareholders. The dividend yield is 2.2%. Add in the share buybacks it is yielding “something” like 4.5%.

I say “something like” because shareholders need to sell their shares in return for cash. Every time, Smiths does a buyback, the shareholders hold fewer WH Smiths shares. Unlike, the dividends where you receive a straight-up cash payment without any strings attached.

Here is the change in Smiths share buybacks and dividends.

How would you fair in ten years, as a WH Smiths Shareholder?

Imagine you purchase 100,000 Smiths shares in 2006 and you pay an average £3.12 per share. That amounts to an initial investment of £312,000 (ignoring transaction fees). After ten years, you would want to ask the following questions:

A. How much would you receive in dividends?
B. How has the share buybacks added to your returns?
C. The number of Smiths shares you will end up by 2016.
D. What is the total return from both the dividends and share buybacks? (In % and absolutes)
E. How much will your WH Smiths shares be worth?
F. What are the total returns after ten years from realised and unrealised gains?

Corresponding Answers

A. After ten years, you would receive a total of £198,908 in dividends.
B. Smith’s share buyback would have contributed a further £189,400 to your coffers.
C. By 2016, the amounts of WH Smiths shares in your portfolio has fallen to 61,749.
D. In ten years, you would have gotten back 63.75% of your original investment via dividends, and 60.7% via share buybacks. So, the total return comes to £388,300.
E. We know that the initial value of WH Smiths shares were £312,000 in 2006. By the end of 2016, your unrealised WH Smiths shares are valued at £1,004,965, a 222% appreciation.
F. Combining these returns (realised or unrealised), your total return is 346%.
The details of your £100,000 investment “year after year” is shown below:

WH Smiths share price without the Buybacks

What would WH Smiths share price look like without the buybacks?
It would look like this:

If we were to assume WH Smiths didn’t do any buybacks, but instead, pay it all in dividends, the number of share outstanding would remain the same.

And using the average market capitalisation in 2016 of £1,839m, then Smiths shares would be worth £10.04 each, instead of £16.27.

That’s enough praise for WH Smiths. Now we search for any possible red flags or weakness in Smiths business model.

WH Smiths Bad Points

When you see growing profits and increasing shareholders return, you can be forgiven for overlooking any weaknesses in the WH Smiths business model.

But, one thing I noticed or doesn’t gel well with the company increasing profitability is their collapsing inventory turnover. That is a concern if you consider that the majority of its business relies on selling goods, rather than services.

One reason is Smiths numerator “Costs of goods sold” has collapsed, but still, they should manage to reduce their inventory levels along with declining sales.

The negative of Smiths inventory turnover will lead to increasing days in holding inventory. This would incur extra storage costs and other holding costs.

Prolonging creditors’ days

Below is the cash cycle chart:

Apart from the increasing inventory days, WH Smiths creditors are having to wait longer for payment. However, this pattern is rather volatile and doesn’t appear to put investors off investing in Smiths.

Question: Is there any particular reasons why creditors’ days are longer?

The other dirty secret is WH Smiths assets.

A look at the depreciation of WH Smiths

WH Smiths rate of depreciation has slowed from 8.9% to 7%. A lower rate of depreciation indicates smaller depreciation charge. It helps to lower expenses and boost profits!

Another angle could be Smiths revaluing assets higher, as their original costs of assets rose from £460m to £539m, despite falling sales. In that case, you can ignore the depreciation charge.

The average age of WH Smiths assets has gotten older by 3.2 years.

Lesson: - The older the asset gets over time, the greater the chance a company will spend big to refresh and maintain the condition of its assets.

For WH Smiths, this may not necessarily apply because they are focused on increasing its operating profits. However, the “bricks and mortar” coverage between their high-street branches and travel branches suggest otherwise (more on that later).

If you think WH Smiths is deliberately “lowering” depreciation charges, then there is an argument against that. One is to use the Worn-Out ratio, a measure of how much value has been written off.

That ratio shows WH Smiths assets represent less than two-thirds of original value from half their original value, a decade ago.
However, it is evident the assets are getting older!

The Ugly Truth about WH Smiths

If you visit a WH Smiths store you may see this:

Or, that

I'm kidding!!!!!!! Now, the real ugly truth, which I’m ONLY hinting at, but shouldn’t be taken as gospel is the retail coverage.
We saw the big drop in sales of their high-street division from £1.1bn to £600m. When you compare that with “SQ. FT.” coverage, it tells a different story.

The high-street division cover 2,827 (Sq. ft.’000s) today, not far from the 3,000 (Sq. ft.’000s) ten years ago, so how is it possible that sales declined so dramatically in that division?

Hmm… That’s a legit question.

We assumed from the start that Smiths been closing down its stores. In fact, the opposite has happened. There are now more stores on the high-street, as it jumped from 543 to 612. Or, it could mean that bigger branches are closing down, while it opens more little ones.

Based on the above assessment. Do you think there is foul play or a misunderstanding between crashing high-street sales and increasing stores?

WH Smiths Valuation

Smiths’ valuations are looking fairly high. Normally, it trades on single-digit of 6s and 7s for EV/EBIT. Now, it trades at 13 times operating earnings, which is doubled the average.

A similar comparison can be made for EV/OCF ratio, but the one difference is it normally trades at 5s and 6s multiples.

So, is this valuation too high?

Well, analysts are forecasting £1.05 per share in earnings for 2017 and £1.09 per share for 2018. We can’t determine the absolute profits because of the company’s share buyback policies.

But, if “per share” increases are that small, despite further buybacks, then profits could be stagnating.

WH Smiths Briefing

Let’s remind us of the objectives in this post, that’s about identifying factors which support a retail stock price.

These are:
A. The growth in Smiths trading profits is a key factor, but it must translate to giving your shareholders a decent return.
B. Don’t sell a retail stock because of a declining revenue trend. Earnings should be your focus. Also, a mature business can attribute falling sales from over expansion, so it is natural for the company to implement economies of scale.
However, a growth retailer with falling sales would be bad.
C. Generating high levels of free cash flow is a positive sign and means the retailer didn’t have to borrow money to pay dividends. It is why WH Smiths debt levels are low.
D. And earning positive amounts of free cash flow gives management the options to increase dividends.

These are a few things you need to watch out for but is not everything. One big factor is the valuation. In the case of WH Smiths, it was a great buy when the company was trading on 6 times EV/EBIT. Now, at 13 times, the market got ahead of fundamentals.

A second factor is future earnings growth and for Smiths this it at a low single-digit (See WH Smiths Valuation). Add that to the high valuation and further share buyback, then fundamentals suggest it is running out of steam.

A third factor is the company’s business cycle. WH Smiths has been delivering for a long time, especially earnings growth. Now, it might be the time when consumers are cautious or picky in their spending.

As for forecasting WH Smith’s share price, I will leave that to the securities firms. If I was going a pick where the shares are going then there is a 60% chance it will trade £15 or under, but an 80% chance it will stay above £12.

Thanks for reading if you made it to the end!

Let’s me pick your brain some more and ask a few questions:
1. Do these factors support a mature retailer’s share price?
2. Do you think WH Smiths valuation looks too high? Therefore, may emulate NEXT PLC.


Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.

Finally, the writer does not own the company’s stock, unless stated otherwise.

 

[Walbrock Research]

Didn’t expect Molins to pull off this disposal, but what did we expect when the shares have been undervalued for so long!

The last time I posted, I said the company needed to invest in their ageing assets. Now, they won’t need to invest as much. Instead, they have a lot more cash at hand.

Before the disposal, Molin's enterprise value was £18m, now it is 25% higher!
Let’s say they invest £8m, that would leave them with £28m-£30m in the bank.

Regarding, their pension schemes, shouldn’t the deficit come down if interest rate or UK Gilts and US Bonds start to rise? Well, that depends on what’s in the composition of Molin's pension assets.

Oh, BTW, with this disposal, I expect the shares to trade around £1.20 per share or higher, giving a market value of £25m. Think about it, if their Tobacco division has similar fundamentals to their packaging division, shouldn’t that be worth at least £20m in a liquidation!
But, I need to do further research, before coming to a full conclusion.

 

[Walbrock Research]

5 Reasons why Investors are shunning Norcros PLC Shares

The post is originally from walbrockresearch.com/home and I have full authority to re-post as I am the author. All images links are charts I've created and helps to interpret the text.

Norcros, the owner of Triton, Croydex and Johnson Tiles has been struggling lately, regarding growth in their share price movement. In fact, Norcros share price has gone nowhere for four years, despite showing clear operational improvement and higher profitability. Here are the anomalies:



If you compare the market value against net income and operating cash flow, it’s like night and day.
So, why are investors shunning this stock?
A tough question that requires a thorough investigation. Here are five reasons investors could concern themselves about Norcros:

South Africa Issue

South Africa has been in the news for its political crisis, which doesn’t help with its social and economic stabilities. The most important effects from its South African would be poor sales generation and a hit on its profits when the Rand get converted back to the British Pound.
The weakness of the South African Rand is noticeable against the U.S. Dollar when it fell from 6 Rand to 12.8 Rand to 1 U.S. Dollar in six years.
Despite the UK seeing a similar weakness, the British Pound is actually stronger than the South African Rand by appreciating from 10 Rand to 16 Rand in the same period.
Now, we compare Norcros South African operations. Sales did stagnate (2011: £72.4m; 2016: £72.9m), but operating profits have grown from £0.2m in 2011 to £4.1m. Today, results saw its South African operation generate £88.9m in sales and £6.4m in operating profits.
So, the weakness in its share price doesn’t come from South Africa.

Foreign Exchange gains/losses

Given the weakness in the British Pound, how prevalent is this to investors? The graph shows big FX losses.

In the last seven years, Norcros saw FX losses totalled £16.5m. Compare that to the net profit of £60.1m during the same period, the company saw slightly more than a quarter its profits have been eaten away by adverse FX.

Growing pension deficit
On an annual basis, Norcros saw its pensions obligation turned from surpluses into deficits in 12 years (See below).




That growing deficit means Norcros will one day have to reduce that deficit from operational cash flow, therefore future profits are expected to come in below expectation because of the out of control pension deficit!!
However, in their latest interim results that deficit grew to £97.8m, which is a £55m increase from a year ago. It looks like the time is coming soon for Norcros. But, today's results saw the pension deficit got reduced to £62.7m, thanks to rising equity prices and gilts yield.
Another interesting fact is the pensioner payroll, which has 7,922 members that saw the company paid out £20m per annum or equivalent of 8.5% in total sales to their retired employees, as contribution.

P.S. The pension scheme has been closed to new entrants since 2013.

The Real Net Debt

This may sound controversial because the traditional way of calculating net debt is total debt minus total cash and cash equivalent.
However, this can mislead investors into a false sense of security.
A company doesn’t need to take on debt, it can delay payments to suppliers. Or, it can let the pension deficit grow larger (see section above).

So, the real net debt should include the following:
On the Debit side: -
Cash, trade receivables and pension surplus.
On the credit side: -
Total debt, finance lease, trade payables and pension deficit.

With that knowledge, you can draw a bar chart comparing the traditional net debt and the real net debt.



As the pension deficit grew, so did the real net debt as it pulled away from the traditional measure of net debt. The real net debt is the second highest since 2005.

Norcros’s Valuation: Cheap or not so cheap

By including pension deficits and changes to receivables and payables, this has affected Norcros PLC enterprise value.
First, an illustration:



The label “New EV” includes the pension deficit.
That graph tells me that a rising pension deficit is responsible for suppressing market valuation of Norcros, and in turn, is the reason why the shares saw no rise. Another interesting fact is that net debt, including the pension deficit, is now greater than Norcros’s Market Capitalisation!!

Other Financial Facts on Norcros

1. Revenue at Norcros grew from £147m in 2005 to £236m by 2016. Today, it reported revenue of £271m.
2. Shareholders’ equity stands at £47.6m on an annual basis, which has been trending lower for six years. But in their latest interim result, equity has fallen to £22.5m, down from £52.2m, a year ago. Now, shareholders’ equity has bounced back to £56.6m.
3. In twelve years, Norcros has paid out a total of £19.1m in dividends.
4. One thing you didn’t know is net investing activities totalled £37.5m since 2005, which worked out as £2.88m per year in net capital expenditure. At the time, depreciation costs have totalled £78.7m or £6.05m per year. Does this mean Norcros hasn’t been maintaining their assets?


Share Price Forecast

This is a simple forecast to make.

Best-Case Scenario: - The share price will rise to £2.20 per share in the next 12 months. (Probability outcome: 30%)
That can happen if the pension deficit gets smaller, with this translating to a rising share price. But Norcros operating profits must remain intact!!

Base-Case Scenario: - The share price will hover between £1.40 to £1.80 in the next 12 months. (Probability outcome: 45%) Hopefully, the pension deficit doesn’t grow larger but start to stabilise. Also, Norcros needs to continue to deliver results for the market.

Worst-Case Scenario: - The shares could drop below £1.40 to £1 in the next 12 to 24 months. (Probability outcome: 25%) This is because Norcros face a “catch-22” situation where they allow themselves to report higher profits without dealing with their pension deficit.

Leaving it to grow organically means Norcros needs to borrow from external sources to plug the pension gap in the near future. This would catch investors by surprise!!!
Secondly, there is a case to be made about Norcros not maintaining their assets. However, this hasn’t affected their operations.

Overall, this company is a hold for now because it is trying to deal with the pension deficits. Investors should be concerned if the equity markets start to fall or gilts yield start falling because that would exacerbate the pension deficit.

P.S. An earlier version was written, but I didn't they were reporting results today, so I included the latest results into my analysis.

Thanks for reading.

Do you agree or disagree with my analysis, please let me know down the comments below!



Disclosure
The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.
Finally, the writer does not own the company’s stock, unless stated otherwise.

 

[Walbrock Research]

9 Red Flags of RM2 International that Investors Should Question

Reposted here on TLF with permission of the original copyright holder.

When you got an experienced management team, as well as independent directors such as Paul Walsh from Diageo and Lord Rose (formerly Stuart Rose from M&S), along with a famous investor in Neil Woodford, whom fund holds the biggest stake in the company (35%).
You think you are on a winner.
Instead, RM2 is one of the worst performers in the market. Since January 2014, the shares collapsed from 88 pence to 14 pence.
Worse still, the company wasted hundreds of millions of pounds by initially pursuing the wrong strategy. Despite this, it needs hundreds of millions of pounds to meet the terms of agreements with their new outsourcing partners.

If you think the share price of 14 pence is cheap, do some research before taking a punt on this stock.


Here are nine to consider: -

An ONE Product Company (Red Flag No. 1)

RM2 has one “high-tech” pallet product called BLOCKPal. However, high-tech this product possesses it’s still a pallet. Secondly, the price of industrial pallets aren’t expensive, you can buy pallets on eBay and on Alibaba.
With prices at single digits, this makes BLOCKPal pallet (with a tracking device) looks expensive to rent and buy.
On top of that, RM2 is in collaboration with AT&T to develop a new tracking device pallet called ELIoT pallets.
We know the product is real, but can they sell enough of it to make RM2 a self-sufficient business.

Manufacture First without Testing the Market (Red Flag No. 2)

When the company raise £130.8m in net proceeds, investors should question the business model.
As a fan of Shark Tank (the U.S. version of Dragons Den), the one question they always ask “wannabe” entrepreneurs are: “What are you going to do with my money?”
And, if the reply is: “I will use it to manufacture and stock up on goods.”
Then, the reply is always the same: “Do you have the orders coming in?”
And, if this turns out to be NO, the sharks will start ripping into their business model (no pun intended).
Apparently, that was the mistake RM2 International has made and they paid a price with their reputation, along with going down the drain.
Even worse, they decided to manufacture the pallets themselves for a time, before outsourcing it to China and Mexico (Q3 2017).

Instead, management should have outsourced their product in the first place, which was obviously the cheaper option!! These actions strike me as suspicious, given the “quality” of their board members.
They should have known better!

Not a Very “HI-TECH” company (Red Flag No. 3)

Looking at the IPO admission, the R&D Spending on developing the pallet is minimal.
From 2010-2013, R&D totals less than $1m or £700,000 (before the company discontinued reporting R&D separately).
So, much for the proprietary technology!

Now, on the fundamentals of the company.

Big Losses are No Surprise (Red Flag No. 4)

The initial decision to self-manufacture didn’t help the company finances. Since 2012, capital investment totalled $68.5m (£52m), however, the real loss came from business strategy to stock up on pallets. That caused total operational losses of $257m or £200m in the same period.
How does it make business sense to build-up inventory without having enough customers to sell to?
That’s the real question. Also, this strategy makes it hard for analysts to project the break-even point, which is why no analysts are covering the stock.
Given the change to outsourcing, expect lower operating costs in the future.

The Curious Case of High Staff Costs (Red Flag No. 5)

The costs per employee are $74,000 last year, or £57,000. These salaries are what software employees get paid for, not manufacturers of pallets.
Here is the trend: -

If you working for RM2 then you are getting paid out up until last year (employees number cut from 500 to 180, due to outsourcing).
Lesson: - Analysts need to recognise if the skill-level is sophisticated enough to warrant higher pay. Right now, this isn’t warranted.

Paying Off Your Suppliers (Red Flag No. 6)

When trade payables ballooned to $12m in 2015 (which was more than their sales) it is not surprising to see RM2 pay off their suppliers the following year, as payables collapsed to $2.7m.

Furthermore, it wouldn’t surprise if the suppliers’ excuse was RM2 doesn’t generate enough sales, so, therefore, we are shortening their credit period.
If you look at RM2 average payment period, it fell from 77 days to 27 days. Below, it shows the “over-manufacturing” when you are paying your suppliers five times more than you generate in sales.

All the Risks are with RM2 (Red Flag No. 7)

In 2016, it outsourced manufacturing to two partners in Jabil Circuit Inc. and Zhenshi (of China).
However, there is serious risks and exposure to RM2.
Jabil Circuit Inc. agreement
The agreement is to acquire at least 188k pallets per quarter over a five-year period. That is 752k pallets per year, a total of 3.76m pallets.
There is a penalty of USD 5.68 per pallet ordered below 143k pallets per quarter. So, if it failed to order pallets for one full quarter, RM2 is liable for a maximum of $812,240 fine.
The penalty applies from April 2017, as they started production in March.
The 143k pallets per quarter equate to 572,000 pallets per year or 47,666 pallets per month. The rate of production in June close to 30k per month.
Also, it will be responsible for excess and obsolete material and inventory.

Zhenshi Holding Group agreement
RM2 agreed to purchase twice as much from their Chinese manufacturer of at least 1.5m pallets per year. Further details of this agreement are kept secret.

These agreements may be normal terms for other businesses, but the projection of manufacturing 2.3m pallets per annum looks unrealistic if they don’t have the sales to back this up.

Double Accounting in financial statements (Red Flag No. 8)

Read their cash flow statement and will notice that Interest Paid and Finance Income, which are both reported on the operating section, also appeared in their investing and financing section.
That is called “double-counting”, and distort the numbers. Here is the screenshot: -

And continues here: -

Selling price and Rental lease per pallet (NOT RED FLAG)
In 2015, it sold of circa 30,000 pallets which generated $3.7m in revenue. That works out as over $120 per pallet. Also, it rented out 230,000 pallets, which created $2.7m in sales or $11.74 per pellet (though most of these pallets weren’t rented for the full-year).

So, in 2016, the number of pallets rented went up by 35k to 265,000. This generated rental sales of $5.7m, or $21.51 per pallet. However, pallet sales fell to $400,000 with the number of pallets sold being undisclosed.
Renting these pallets are five times cheaper than buying.

OUTLOOK (NOT RED FLAG)
The following information is interpreted as I understand with some assumptions made. Please critique and offer your interpretations.

Expect lower cash burn

Before it outsourced manufacturing, the cash burn was $1.9m per month in the last six months of 2016. However, that fell to $1.4m per month in the first five months of 2017, but expect cash burn to increase to $1.7m per month, as it includes the wind-down from their Canadian operations. A total of $18.9m.
Add in one-time costs of $5.1m and $0.6m on Luxembourg VAT.

Forecast Sales
I wish the company would draw up a table to illustrate future orders.
According to the 2016’s annual report, here is their outlook for 2017: -
1. Annual full-year production is expected at 467,000 pellets.
2. The company acquires minimum funding of USD 34.0m to cover issued purchase orders and forecasts orders.
3. It will shortly undertake negotiations to arrange a larger additional financing which is expected to amount to at least USD 65.0m or £50m.
4. It says it has 1.6m pallet opportunities constitute the current commercial pipeline, of which 9% represent straight sales and 91% rentals (either flat fee or per trip) and of which 62% are ELIoT pallets and 38% are BLOCKPal pallets.
Despite all that, there aren’t any projection of 2017’s sales, only the costs of manufacturing.

Management Not So Confident (Red Flag No. 9)

Management didn’t appear confident in the business and made several suggestions that the purchase orders were dependent on the success of external funding.
When looking beyond 2017, management made funding concerns their number one major factor.
To anyone, it is sending a clear signal that funding is no guarantee.
Despite these long-term uncertainties, in the short-term, the business remains operational until the end of this year.
That’s not good enough for long-term investors!!

Convertible Preferred Shares (NOT RED FLAG)

Of the total 92,487,729 Convertible Preferred Shares to be issued, the following were issued as follows: -
No. of shares Type Price Financing (£m)
4,591,743 Class B £0.35 1.6
41,580,215 Normal £0.16125 6.76
46,315771 Normal £0.16125 7.53

A total of £15.9m or $20m.
That will to further dilution to the share price, but more worryingly is the further fundraising at the end of this year. The size is as big as £50m.

Valuation and Strategy (NOT RED FLAG)
The current market valuation of £52m at 14 pence is too high given that it destroyed hundreds of millions of pounds in value by pursuing the wrong business strategy.

What should you do?
If you are new to this company, then I suggest you wait for them to deliver their results.
Take their 1.6m pallets pipeline and using their assumptions. That is 91% rental sales at $22 per unit. It would give a sale forecast of $32m with the remaining outright sales of $110 per unit makes it $15.84m, giving a grand total of $48m in revenue.
That is only achieved in a few years’ time.
Leaving you to ponder, if this represents breakeven. If not, then the current valuation of £52m looks too high.
Also, people shouldn’t forget about the future rise of shares outstanding and dilute the share price. For example, the company can be worth £52m, and trades at 5 pence per share, just because of the increase in the share count.

The best strategy is to observe it for two years and see if it genuinely has a business worth investing. More importantly, is to avoid investing at current levels because the risk of dilution is at 100% and there is a real potential of failure.

Verdict: - Best avoid for a few years.
If you this post, then please subscribe and share it.

Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.
Finally, the writer does not own the company’s stock, unless stated otherwise.

 

[up-down]

i still have about 1200 shares of wh smith bought about 4-6 pounds per share many years ago ,about 25 pounds per share will be the the peak, i think , i also had next about 5-8 pounds per share sold around 28 pound's.i never think UK shares will be easily reach 50 pounds per share what a shame .failed on M$ RR but not that bad
I bought FB 2013 paypal last year and worldpay just few day ago what a surprise movement. a good understanding of share movement is very important.
.

 

[Walbrock Research]

As Inflation returns, will we see a recovery in the share price of Sainsbury, Morriso

After three years in the doldrums that has even caught Warren Buffett out (his Tesco’s stake cost him a lot of money).

Is this the time to consider investing in Sainsbury’s, Morrisons and Tesco?
Or, will we see further problems ahead?

To be fair, both Sainsbury and Tesco’s share price saw stabilisation, while Morrison’s shares are up 70% from their lows of £1.39.

But for a sustainable recovery, we need to understand the factors that are driving the UK grocery market.

Let’s get started.

UK Grocery Market – Identifying the Driving Force

Inflation, Inflation and Inflation!

Inflation plays an important role for grocers because they can raise prices to earn themselves higher margins than normal. But the past three years saw consumer inflation fall close to zero, but food prices went into deflation and are recovering.

Food inflation is currently at 2.1% and is a big factor in the recovery of like-for-like sales to the big supermarkets.

Whether this is a temporary recovery or a permanent recovery, it is too early to tell. In the past rising food prices resulted in profits bonanza for the “BIG FOUR” UK supermarkets. Now, the game has changed.


New Players in Town

Well, these new players have been operating in the UK since the 1990s. Only recently, and I mean four or five years have they made a dent to the big supermarkets by eating away their market share. (See Below)

Table 1: - UK Grocery Market Share

For both Aldi and Lidl, they now account for 11.9% of the UK grocery market and have gained 7.3% in market share from 4.6%, more than a decade ago.

To put this in perspective, both Aldi and Lidl have achieved average market share growth of 10% and 8.4% per year for the past ten years, while Waitrose grew 2.4% per year.

Meanwhile, the BIG FOUR saw average market share decline of between 0% and 1.1% per year.

This market share growth doesn’t come from growing sales at existing stores, but from opening new ones.

Aldi is opening 70 new stores in the UK, but their long-term ambition lies in opening 1,000 new stores to total 2,500 stores, which would rival Tesco. For Lidl, they are looking at opening 60 new stores per year.

That strategy will encroach upon the existing stores of the “Big Four” and will cannibalise their sales. At the same time, it forces them to lower prices to match discounters’ prices, putting pressure on margins.

Will the size of the UK Grocery market save the “BIG FOUR”?

Sales aren’t the issue. For instance, Tesco had 31.1% market share in 2006 with UK revenue at £29.9bn. Eleven years later, Tesco grew UK revenue to £43.5bn, but market share fell to 27.5%.
That’s down to the growth in overall UK grocery market (and the demise of non-food businesses). In that period, the UK grocery market has increased by £51.3bn or 40% increase.

If this continues in the next decade, the UK Grocery market could reach £240bn to £250bn a year. Then you could conclude that the pie is big enough for all players.
That is the wrong conclusion because sales aren’t the issue, it is cash earnings. It raises this question:
How much margins are they sacrificing for sales?
If the “making money” part doesn’t exist, then it is not worth being in business.

Now, for the fundamentals.


Companies Fundamentals

Before we get into the fundamentals. Here are some brief backgrounds: -

1. Sainsbury’s has retaken second place from Asda in 2016 by performing less badly. Also, they recently bought Argos owner The Home Retail Group for over £1bn, which extends their non-food products availability.

2. The UK biggest grocer Tesco is dealing with the fallout of an accounting scandal that saw shareholders get compensated for £85m.
In order to restore some reputation, they decided to write down their assets causing them to report the biggest accounting loss (£6.4bn) in history from a UK retailer.
Tesco’s market share fell from 31.3% to 27.5% in the past eight years.

3. Morrison’s share price recovery from their lows in 2016 is down to rumours of a takeover from a private equity firm.

But a better takeover rumour could come from Amazon because both companies have a partnership deal to supply Amazon Fresh. Given Amazon takeover of Whole Foods, this is becoming a real possibility. Meanwhile, their partnership could increase profits by £50m to £100m.

However, investors aren’t happy with management pay structure, with more than half voting against big bonus increases from long-term performances (an increase from 240% to 300% of basic salary). Also, EPS performance target is lower to 5-10% from 6-13% growth.

Staff Productivity

Supermarkets employ a lot of people (Tesco’s 218k, Morrison’s 77k and Sainsbury’s 119k full-time equivalent UK employees), therefore relevant to operational performances.

Using the average “full-time” employee data we depict the following:
Initially, both Sainsbury and Tesco produces more than Morrisons (£30k to £40k more sales per staff).

Over time, Morrisons has caught up.

Meanwhile, Tesco’s sales maturity turned into a decline with sales per staff falling below £200k.

(P.S. Tesco’s figures are based on their UK business.)
With sales per staff stagnating, how will the grocers manage to keep costs low and maintain margins?

The answer is they couldn’t (see below).

Using normalised earnings, all three grocers saw profit per staff falling.
Tesco was the biggest faller, as it fell below their rivals.

The reason is down to staff costs rising per person. For example, Sainsbury’s staff costs rose from £18k to £24k in ten years. The problem began when sales per staff stall, while wages rose a further £1.3k (£24k minus £22.7k).
Still, employee data is a lagging indicator, unless you are Tesco!


Cash Cycle
All three register negative cash cycles. After all, customers were paying for food in cash.

However, a closer look would see analysts pick Morrisons as the odd one out.

Morrisons minus 32 days, compared Sainsbury’s minus 11 days and Tesco’s minus 12 days helps reduce working capital requirements, but this leads to delaying payments to suppliers. The 10-year average is 35 days and currently, stands at 50 days. Both Sainsbury and Tesco payable period are 38 days and 34 days.

Also, Morrisons trade payables have doubled, compared with sales growing by 35% in the same period, another way of checking payment delays.

Tesco accounting scandal is due to delaying payments to suppliers to bolster cash earnings. I’m not saying Morrisons is guilty of that, but it warrants further investigation.
Meanwhile, Sainsbury deteriorating cash cycle is due to their acquisition of Argos.



Capex and Assets

Supermarkets are “asset heavy” businesses, despite the growth in online shopping. Therefore, it’s a good idea to examine the value placed on these assets and spot changes to capex spending.

Below is an overall look:

The first obvious trend is the slowdown capital spending as capex to depreciation fell to either 1.1 or 1.2, a big drop from their ten-year average of 1.8 to 2.4 times. It barely sustaining their business size.

While this is going on, Morrisons and Sainsbury are saving a few hundreds of millions in capex, whereas Tesco saved around £2bn to £2.5bn each year for the past two years.

Low spending won’t last for long. Already, Tesco is eyeing a purchase of Booker for £3.7bn (if successful).

Sales growth for all three averages 3%-4% per year, compared with double-digit growth from Lidl and Aldi.

Looking at assets valuation, Tesco overall assets are at 54% of original costs, compared with the average 70%, due to the writedowns of between £4bn and £4.5bn. When compared to Sainsbury’s and Morrisons, Tesco’s assets are 10% and 14% lower respectively.

Now, let’s see the compositions of the overall assets.

To make things simple, let’s divide this into two sections:

Land and Building/Freehold and Leasehold

Both Tesco and Morrisons are valuing their prized assets at less than 70% of original costs, whereas Sainsbury’s is putting a value of 76%.
On their ten-year average, all three grocers had these assets above 80% of original costs.

Revaluation, a probability?

Take Tesco, for example. If business returns back to normal, they can revalue their assets back above 80% and could potentially realise a £3bn in accounting gain. Or, Tesco could revalue their assets slowly plug any shortfall of earnings over a number of years.

Fixtures and Equipment

In 2015, Morrisons wrote off £1.5bn of assets. (See annual report 2016) Although they reported £1.1bn of impairments, they didn’t revalue the net book value (the number that gets reported in the balance sheet) causing it to register 60% of original costs, rather than the average of 36%.

Normally, writedowns are reflected on the balance sheet.
That resulted in shareholders’ equity being £300m to £400m higher.
Instead of Morrison reporting 2016’s equity of £3.75bn, it should be around £3.3bn to £3.35bn.


Unlike, Tesco, Morrisons won’t see improvements in profits from revaluations.
Again, Tesco has written-off more of their fixtures with NBV at 23.5% of original costs.

Overall, Tesco will see asset value realisations, if business gets back to normal. That remains a distant dream for the traditional supermarkets.

Debt

All three supermarkets saw improvements in their net debt positions with Tesco seeing the largest.

But, what if these improvements are slightly exaggerated?
For the diligent analysts, another appropriate measure is what I term “Real Net Debt.”

It includes:

Original net debt;
Trade Receivables (minus);
Trade Payables (plus) and
Pension deficits/surplus (plus/minus).

It resulted in this chart.

Improvements not that noticeable, also it reflects a shift in borrowing strategy to “non-interest” credit lines.

Still, these figures are better than 2015.

Some of the debt reductions are down to disposal and sales and leaseback.
For instance, Tesco sold their South Korean business Homeplus for £4.2bn, Dobbies Garden Centres for £200m, Lazada stake for £90m, Private jets for £66m, and Harris + Hoole coffee shops for an undisclosed sum.

Meanwhile, Morrisons net debt improvements are due to increasing transactions of its sales and leaseback, which saw operating lease growing rapidly (see section: Operating Lease). Anyone who studied Tesco diligently knows this method is short-term and leads to long-term problems.

Making sense of net debt and real net debt

Comparing it to sales and assets paint a picture on the proportion to the size of the business.

Table 2: - Debt, compared to Sales and Assets

When it came to net debt, all three saw big improvements, but real net debt exposes Tesco and Morrisons (current figures above ten-year averages), while Sainsbury produces the best improvement.

For proof, look no further than “net interest costs”, where Sainsbury is falling, while Tesco and Morrisons are rising.

Table 3: - Debt against Normalised Earnings

Again, Sainsbury made the best improvements, while Tesco and Morrisons saw high multiples.
To be fair, Sainsbury has been highly-leveraged in the past, that is now seeing slight improvements.

Pensions

The effect of the UK interest rate being close to zero and the stock market at record highs resulted in lower Gilts yield and dividends yield. That has caused pensions assets to return money every year (in proportion to pension assets size).

Here are some interesting data, when comparing pension assets in 2006 to today: -

Sainsbury’s pension assets grew by 167%, but the absolute returns increase a measly 30%, which currently yields 2.78%, a far cry from 5.74%.

Tesco grew their pension assets by 283% to achieve 84.2% in expected returns. Current yield is at 2.92% from over 6%.

Meanwhile, Morrisons increased their assets by 204% to increase expected returns by 74%, while it is currently yielding above 3%.



With the continuation of low returns, these grocers have to contribute more of their profits to pay for past employees’ retirements.

This trend affects all businesses that have established pension schemes.



That leads to another problem, which is pension liabilities accounting for a greater proportion of company’s sales.



Table 4: - Pension’s Liabilities as % of Sales

Tesco saw the biggest increase in their pension liabilities and is second behind Sainsbury.

Tesco saw pension liabilities increased by 24% percentage points, compared with Morrison’s 10.8% and Sainsbury’s 14%.

You would think a growing pension liabilities lead to higher pension deficits. This isn’t the case for Sainsbury and Morrisons, but I’m no actuarial. So, a further investigation is needed.

Operating Lease

In the past, Tesco is guilty of using sales and leaseback to book non-core profits. That quick fix to boost EPS, and not focusing on core business has cost them a lot of money in wasted investment. Now they are deleveraging through disposals.
On the other hand, Morrisons been engaging in sales and leaseback that resulted in £500m of property sales in the past.

Despite the size of Tesco’s operating lease its net rental expense as % of sales have fallen below that of Sainsbury. At 1.87%, it is lower than Sainsbury’s 2.49%, while Morrisons rents account for 0.7%.

A look at total operating lease against sales gives the reason why Sainsbury pays more in rent.

Table 5: - Operating Leases

Sainsbury’s operating lease accounts for 40% of sales making it the highest, but they operated at this level for a while.
The deleveraging of leasing is apparent in Tesco, as it saw operating lease account for 22% of sales, having peaked at 27% in 2012.

Despite, seeing low operating lease from Morrisons, theirs have increased from 4-5% to 15%. That is alarming, but unsurprising as bosses choose the easy route to realise value.

Given the low levels of rental expenses, does this pose a threat to companies’ distribution of earnings? Apparently, it does, if we use the fixed charge coverage ratio.

The coverage from earnings has all but collapsed. And it has affected their ability to pay dividends with Tesco cancelling them altogether. Both Morrisons and Sainsbury saw some big dividends reduction.

Cumulative Free Cash Flow

Free cash flow is an important indicator of a competitive business it is also volatile, which depends on the levels of capex spending.

The solution is to cumulate all cash inflows and cash outflows over a period of time to work out the resultant free cash flow. This method would smooth out some volatilities and give an accurate reading.

This makes for some interesting reading.

Overall, Morrisons is likely to convert post-tax earnings into free cash flow at an average rate of 37.73%. This means it produces an average free cash flow of £200m per annum enough to pay their annual dividend, which average £196m.

Sainsbury registers a negative free cash flow of £319m.

Tesco has registered cumulative free cash flow of £3.2bn, equivalent to 11% of free cash flow. Like I said before, it depends on capex spending and for Tesco, they saved £5bn in two years!



Supermarket’s Valuations

Companies with huge debts and a pension deficit require a conservative numerator. Normally, I would use Enterprise Value, but I will adjust the EV to include receivables, payables and pension deficits. (Known as Adjusted-EV)


Using five widely used measurements, we get this: -

Sainsbury is the cheapest company when compared to their 10-year average. Also, Sainsbury has a much lower valuation overall.
However, these valuations are very volatile and the numbers are inconsistent given the growing threat from new competition.
But, most importantly, these basic valuations can’t tell you if the shares are a buy or sell!

One other method is to use the Earnings Power Value.

Earnings Power Value/ Cash Earnings Power Value

The logic behind earnings power of a company is to look at the profits of a business over a long period of time and then estimating what the average profits would be when taking into account all likely business conditions.
To see how I calculate Earnings Power Value (EPV) and to learn more, read this article by Phil Oakley.

For those sceptical about accounting earnings, I also include the use of after-cash tax operating cash flow measure.

The general rule is to buy shares when (EPV) per share is above 100% of current share price because the market is discounting the fundamentals. And like every valuation tool it fails to recognise external threats and internal failings.
Another issue is choosing the right interest rate, this lead to Phil Oakley’s guide to choosing interest rate.

• Large and less risky companies (FTSE 350) - 7% to 9%
• Smaller and more risky (lots of debt or volatile profits) - 10 to 12%
• Very small and very risky - 15% or more

(P.S. The higher the interest rate chosen, the lower the Earnings Power per share.)

For this exercise, I have chosen to use three interest rates of 9%, 10% and 11%.
(N.B.: My focused analysis is interest rate at 9% unless stated)

First up Sainsbury’s.

On an earnings power value basis, Sainsbury valuation was very expensive ten-year ago, when it had a 75% premium. One reason was Qatar’s sovereign fund wanted to buy the whole supermarket for £12bn.
As that didn’t materialise, the shares took a tumble and trade around £3, cutting the premium by half.
A ten-year trend sees EPV per share averages £2.19 with the current price at £2.06. That is lower than the current share price of £2.45 or a 16% premium, although this is lower than the average premium of 29%.

Using the cash earnings power value, the opposite is true. Even at a higher interest rate of 11%, it trades at a discount of 10% to 20%.
On a 10-year basis, it trades at an average 49% discount, but it currently trades at a premium.

Next up is Morrisons.

For Morrisons, it is trading at a premium of 34% but fundamentals are improving.
But, the cash earnings power value suggest value as the current share price gives it an 86% discount, compared with the ten-year average of 33%. Some of that is attributable to Morrisons delaying cash payment to shareholders to boost cash earnings. (Refer back: Cash Cycle)

Finally, we move onto Tesco.

Despite seeing a 70% share price collapse, the EPV per share decline is greater and currently stands at 65 pence per share, a 63% premium and higher than their ten-year average of 30%.

Even shocking is if you require an 11% interest rate, due to risk this cuts EPV per share by half to 30 pence and makes the current price even more expensive.

Right now, the earnings power value is telling you to stay away from Tesco’s share price as it is fundamentally weak.





Which supermarket should you invest in?

None of the above.

That’s because all three companies have their separate issues.

You can make the case for and against each company, here is a summary below: -

The case FOR SAINSBURY’S ARE: -

Solid Earnings;

Normal cash cycle;

Deleveraging.

The case AGAINST SAINSBURY’S ARE: -

Assets are perfectly valued, no revaluation gains;

Growing operating lease;

Higher rental expense as % of sales;

Negative cumulative free cash flow since 2006;

Low fixed interest charges.



The case FOR MORRISONS are: -

Improving earnings; some of this is from increasing use of sales and leaseback;

Growing staff productivity;

Low rental charges;

Low operating lease, but this is growing.

The case AGAINST MORRISONS are: -

Shareholders’ Equity looks overvalued because of no change in the net book value of fixtures and equipment, despite writing off £1.5bn of original costs;

Average payables period is at their highest of 50 days, whereas Tesco and Sainsbury are below 40 days, helping to boost cash earnings;



The case FOR TESCO are: -

Potential future accounting profits, due to kitchen-sinking their assets;

Some improvements in debt deleveraging;

Operating lease has peaked and is now declining;



The case AGAINST TESCO are: -

Still, highly-leveraged when measuring debt against normalised earnings;

Growing pension deficits;

Loss of reputation following the accounting scandal;

Fixed Interest coverage is the weakest;

Earnings power value per share is 65 pence per share compared to current share price of £1.73 giving it a 63% premium.





The Shrinking Market Share will keep on Shrinking

Earlier in this post, I mentioned both Lidl and Aldi controlling up to 11.9% from 4.6% in 2006. That market share growth is at an annual pace of 10% for Aldi and 8.4% for Lidl.

What if this continues for another 10 years?

How will this affect UK supermarkets?

Achieving the same growth rate looks unlikely, so I will lower the growth rate. Instead, there are three growth rate scenarios.

Here are the results: -

If we choose the lowest market share growth rate of 6% for Aldi and 5% for Lidl, then the combined market share at the end of 2027 will come to 20.9% another 9% increase and also higher than the 7.3%!
At the high-end (Aldi grows at 8% and Lidl at 7%), it gives a combined market share of 24.7%, a 12.8% increase.
What does this mean?
Aldi and Lidl will take more of the pie and causes more miserably for the rest of the supermarkets.
It will add further pressure for cost savings.


Amazon Fresh

To add further headaches there is another threat brewing, that is Amazon launching their Amazon Fresh in the UK and selling food online. The one area where supermarkets are seeing double-digit growth is being targeted by a company that has millions of UK customers.
Another thing, the recent purchase of Whole Foods show the company intends to enter the bricks and mortar space too.
If there is one company that would benefit from Amazon it is Morrisons because they have a partnership to supply groceries. With speculation of a takeover from Amazon growing.
However, the rise in Morrisons share price has priced in some of that takeover value.

Final Thoughts

Unless there is a law limiting foreign ownership of the UK grocery market, then this isn’t good for Tesco, Sainsbury, Morrisons and Asda.
If Lidl and Aldi gain a further 9% to 13% in the next decade, you will greater falls in market share from the big four. Cause and Effect!!
So, it is not surprising that both Sainsbury’s and Tesco are moving away from their core business to venture into non-foods and wholesaling. However, this is no means a successful move, especially Sainsbury buying Argos (fierce competition from Amazon).

For those long-term shareholders, it is still an avoid for the big UK supermarket stocks.

Disclosure

The opinions expressed by the writer is for entertainment and research purposes. It does not constitute professional investment advice. Data is correct on available information at the time.
Finally, the writer does not own the company’s stock, unless stated otherwise.

 

[Walbrock Research]

Explaining Carillion PLC £845M impairments

To explain why Carillion had to make £845m provisional impairment charge, you must follow 5 sequential FACTORS leading up to this conclusion: -
1. Since last major acquisition in 2011, Carillion EPS fell from 37.2 pence in 2012 to 28.9 pence in 2016.

2. Carillion acquires THREE major acquisitions costing £1.2bn. It has combined sales of £3.5bn or 70% of group sales.
After acquisitions, performance is poor. Here’s why: Cumulative net LOSS = £20m! And Cumulative operating LOSS of over £200m. This begs the question:
“How on earth did they achieve cumulative operating profits (since 2007) of £1.55bn and cumulative net profit of £1.27bn?”

3. One explanation is utilising their Receivables. Their trade receivables numbers are perfectly fine, but the “Other Receivables” is a big concern. (See graph here http://bit.ly/2vu6U8J ) Using total receivables, as % of sales as a measure, it has averaged 30.5% in the past four years (in contrast with trade receivables). Normally comes in at 21%-22%.
The 8%-9% difference is equivalent to £300m-£400m per year for past four years. That boost = GREATER than operating profits!

4. Another sign of manipulating profits is comparing cumulative cash earnings (£166.4m) and accounting earnings (£688.9m) in the last five years. The difference is startling.

5. The BIGGEST FACTOR is that fund managers have noticed High Carillion’s total receivables and high total payables as % of sales have averaged 37.6% (normally at 29.5%). This is a double whammy because rising credit sales will lead to bigger provisions and asset write-downs. (this explains £845m impairments) While delaying payments to suppliers for the future leads cash crunch. (it explains asset disposals and Rights issue rumours)

For detailed analysis, go to walbrockresearch.com/home/