A valuation narrative

" What sets pricing? Supply and demand. Mood and momentum. What sets value? Cash flows, growth and risk. Can the two give you different results? Absolutely. "

The quote above come from the Google Talks by Damodaran, the King of Valuation.

Valuation is subjective. I find DCF's and any other technical measures bring out the worst heuristics and biases that investors face. Searching for a WACC or cost of equity is easy to use a round number such as 10%, and assumptions for growth can be backed out of your perceived (the price you aim the valuation exercise to give you) target price.

I've made my valuation process this 'simple': concentrate on finding a narrative for growth, risk and cash flows. The story should give logical reasoning for all assumptions, for example how much does a company need to reinvest to earn these rates of growth and cash flows? I am now in the process of making a checklist that will help me build this narrative.

DCF comes in two parts: the cash flow, and the discount rate. Risk, growth and cash flow. Tell a narrative to get your assumptions for these three factors that drive the valuation. Find ranges of assumptions based on bounded rationality. Use 'laws of the universe' when building a narrative, i.e. an operational margin of 50% is not sustainable in the long term and doesn't come for free.

Building a narrative reminded me of Munger's quote:

'People calculate too much and think too little'

Berkeley Group Holdings

Berekely Group Holdings (BERK)

Px - £35

Target Price -15x to 19x 2015 NOPAT.

Fundamental drivers of the business

Housebuilding is a capital-intensive business. The more capital you invest, the more profit you can make just as in any commoditized business. The challenges in the business come from the competition you have purchasing the sought after land, and the margins you earn are constrained by the demand and availability of the houses nearby.

It seems logical to value homebuilders on the capital they have on their balance sheet and the ability of this capital to generate cash. Tangible book value is the assets that generate earnings for homebuilders, not intangibles so much as it would for a company such as Microsoft. It seems as if the market understands the cyclical nature of house builders and therefore never gets too excited and bids them to high PE multiples. Forward PE is relatively low and P/TBV is at a significant premium, which actually indicates that the market questions the sustainability of recent earnings.

Company	ROE	Price to Tangible Book	Current ROIC	EV/NOPAT
Barratt Developments	11.45	2.45	20.59	10
Bellway PLC	17.42	2.11	22.03	15.15
Berkeley Group Holdings	27.33	2.87	39.89	9.6
Bovis Homes Group	12.6	1.63	15.34	11.5
Crest Nicholson Holdings PLC	21.78	2.6	25.41	14.4
Persimmon PLC	21.03	3.28	33.54	15.56
Taylor Wimpey	16.81	2.69	20.09	16.45

Therefore, buying homebuilders today expecting a re-rating in market multiples is nonsensical as investors know the cyclicality of the business and therefore even in the boom years the PE ratio is never hugely inflated. Berkeley has a 5-year average PE of 12.8 and PESN of 13.8 BERK current PE is at 12 and therefore I do not expect a large expansion in multiple to driver return.

Sustainable earnings growth

If we cannot expect re-rating in terms of multiple expansion, we need favourable fundamentals to drive earnings. These are mostly driven by mortgage availability, government policy, FDI and overall supply and demand of housing and land. I feel that we have been in a pretty ideal environment for the past couple of years, are we too late to join the party?

One fact remains, there is a shortage of housing in the UK, especially London and South East, and the government are publicly supporting housing formations. The future path of rising rates will probably net off, I hope, increases in real wages and therefore an investment thesis here is based on a continuation of the fundamental factors that drive the business.

Paying over book value for a house builder such as BERK does not worry me as much, due to the geography and type of housing they build. Firstly, London and the South East is an area that is subject to persistent demand due to urbanization and foreign direct investment. The UK government and it’s Help to Buy scheme has also pledged to complete £12bn of guarantees over the life of the scheme and as of June 2015 they have only completed £1bn. Spare capacity for mortgage growth to continue its trend and I am somewhat confident the BoE rate rise will not affect this too much.

The Office for National Statistics report that in London there is an estimated 2800 hectares of land available for housing in London that is not in use or available for redevelopment, and over 6000 hectares in the South East which can provide around 330,000 and 210,000 houses respectively. Seasonally adjusted housing starts are still 32% below the March quarter 2007 peak with completions 26% below the peak, highlighting some spare capacity within the industry. So the supply is limited, although available, albeit at a certain price, and therefore the issue comes with not finding the supply to build, but finding it at favourable prices. This is where the business model of BERK will prosper. By taking on complex plots of brownfield land, they have full support of the government who introduced policies in 2010 and extended in 2014 to target brownfield sites for housing and build around 200,000 houses on brownfield sites by 2020.

Business Strategy

With regards to land cost, BERK need to ensure the spread between housing sales and land purchase is adequate, and their timing of purchases throughout the cycle is not prone to basic behavioral biases, i.e. overconfidence buying at peak of market. This emphasizes the importance of ROIC in this business and the expertise of management in capital allocation being crucial to the success of the firm. BERK emphasise their long-term outlook on their business and claim to understand the cyclical nature of the market, which determines their buying habits.

BERK has consistently increased capital invested and therefore inventories too, as these are the assets that generates return in the business. Capital has increased from around £1bn in 2006 to over £3.5bn today and ROIC has followed from 10% to over 35% in the same period. Having a consistently increasing asset base de risks the business from any huge fluctuations in underlying housing prices. On this capital, the high and increasing levels of ROIC highlight the profitability of the business and the great capital allocation of management.

Understanding the markets in which we operate is central to Berkeley’s strategy and gives us the confidence to buy land without an implementable planning consent where we understand what local stakeholders want. (BERK 2015 10k)

BERK is in the business of placemaking, not just housebuilding. They claim to create value by identifying and purchasing land and to then build and sell. They take on complex sites and ‘brownfield’ land (areas that previously had commercial or industrial use) and then seek to create developments. This is a very different business model than its competitors who seem to buy ‘consented land’ or housing sites.

The firm takes the risk of buying land that has not yet been consented to developments. This is a huge risk, which can weigh on profits and margins if the acquired land has planning permission rejected. BERK is delivering 10% of all new homes in London and has unconditional contracts for sales that deliver £3bn in cash over the next 3 years. The firm currently has 37,473 plots of land plus strategic options on 5,000 plots. At an average selling price of £456,000 this gives gross margin of £5.2bn (c30%) on the balance sheet. Gross margin is driven by house prices and land purchasing strategy. The cheaper you buy the assets, the higher the margin when developed and monetized. Land supply is constrained and in demand, therefore margins will definitely be squeezed going forward due to new entrants and scale. Land plots and inventories have a CAGR of 5% and 13% respectively for the last 6 years and capital employed has increased 2.2x over the 6-year period. Capital is crucial to buy the land that eventually generates the gross margin and flows to earnings.

Valuation

EV/NOPAT – concentrating on the ROIC of Berkeley to value the homebuilder provides some metric of valuation to target. Berkeley has been able to grow rapidly post-crisis due to their successful and shrewd business of buying property at depressed prices during the housing crisis and therefore have been able to greatly expand margins in recent years as they have sold these properties. In the long run these high returns on capital of over 30% are not sustainable and therefore to find a fair value we use the 10-year average ROIC of 19%.

Using a WACC of 10% and long-term growth rate of 3% (inflation + greater asset price growth in London and South East). Using 10-year average range of ROIC 15-19% this gives a fair value range of 11.4-12x 2020E NOPAT.

Current valuation is 9.7x Apr 2015 diluted NOPAT. Now how much do we expect Berkeley to grow? Revenue and EPS has a CAGR of 33% and 44% respectively over the last 5 years. Assuming BERK grow at 10-15% per year for the next 5 years, this implies that BERK’s fair value is 1.6x-2x 2015 NOPAT. Hence the fair value and price target of BERK for the next five years is 15.5x to 19x 2015 NOPAT which gives a price target range of £52-57.5 providing a 46% upside potential over the next 5 years.

BERK also pledged in 2012 to return £13 per share to shareholders by 2021. They will have already committed £4.34 by Sept 2015; therefore £8.33 in dividends from 2016-21 is on average £1.73 a year which yields 5% at current prices and when discounted at 10% this gives a PV of £6.57. This provides 18% of return on top of any potential price appreciation driven by earnings growth.

Sanjay Bakshi Podcast

One of my favourite blogs to read on a Sunday morning is Shane Parrish's Farnam Street a blog covering all disciplines, with plenty of Mungerisms, great book recommendations and learning material. This week covered a Podcast with Sanjay Bakshi, an Indian Finance professor and successful value investor, founder of Value Quest Capital LLP (audited 24% gross return from 2002-12). Found a post on his career and his journey to become a value investor here. Fascinating.

10 points from the talk:

1. He reads on a Kindle, which when he makes annotations, sends the notes to the cloud which he can then access when the book is finished. This seems to be much easier and more efficient than underlying text in the book which can be a pain to find at a later date. 

2. Charlie Munger's multi disciplinary approach is essential to becoming a complete investor, i.e you cannot understand economics without understanding psychology and incentives. 

3. Financial independence is key to being able to think truly long-term like Berkshire. 

4. Talks about a 'physical space', somewhere with no distractions that enables one to make rational decisions. He refers to Guy Spier's room with no electronic devices and Buffett's move to Omaha from New York. 

5. He looks to minimise noise. He doesn't have a Bloomberg terminal or watch CNBC. Short term results, quarterly reports and next quarters EPS estimates are nothing but noise. He takes See's Candies as an example. A wonderful business that loses money 8 months a year but is hugely profitable for the remaining 4. Looking at short term info is noise. 

6. Low cost provider is the most sustainable moat. Speaks about Costco's business model. Sale of low cost brands, highly scalable, customers provide the business a float, pays customers better than competitors. Will look to do a post on Costco soon. 

7. Slow changes go unnoticed. Boiling frog syndrome - myth that placing a frog in boiling water it will jump out, but place it in luke warm water and then slowly boil it will not perceive death and die.

8. Give descriptive names to mental models to help retrieve them from your memory. 

9. Looking for a business/entrepreneur that is risk averse but not loss averse. Finding managers that are making asymmetric bets, not scared to take the right risk. This led me to think of a point made by Mohnish Pabrai about Bill Gates and Microsoft. Pabrai argues that Microsoft was not risky in the early stages. The actual amount of capital injected into Microsoft was very small but Gates dropped out of Harvard and concentrated solely on the project. He argues where the true risk of this project lies? If it succeeds it can change the world, literally, and if it fails, well Gates can go back to Harvard, complete his degree then find a job. Low downside risk, huge uncertainty. Good combination of a business or venture. 

10. Poor Charlie's Almanack is the book that has influenced him most.

Central Asia Metals

Central Asia Metals (CAM) – 09/09/15

Dividend yield – 6.08%

P/Exp FCF – 9.34

PT - £2.04

 
·      This is not conventional mining and therefore the cost structure and margins are much better than other miners.
·      Dividend policy offers healthy current and future yield. Investors are being paid adequately to hold.
·      Safe access to mining sector with the lowest cost producer in industry with very high FCF/dividend cover in coming years.
·      This actually becomes an income play plus a low risk exposure to future rising copper prices. 

Central Asia Metals (CAM) is a low cost copper producer and base metal exploration company with it's main operation in Kazakhstan and Mongolia. Their main operation in Kounrad, Kazakhstan is the business I am interested in. CAM are the sole owners and operators of a copper recovery plant, a facility that recovers copper from so-called 'waste dumps' that remain from the original Kounrad mine back from the 1930's. Long story short, they are very low cost producers of copper. 

CAM plan to produce 12,000 tonnes of copper in 2015 and at the current price p/t of copper is $5,390 will give around $64m of revenue in 2015 year-end, a 15% decrease yoy. They then plan to ramp up to 15,000 tonnes, and assuming this depressed copper price this gives us $80m annually of revenue from 2017 onwards.

Cost base

CAM has a fully absorbed cost of $1.65/lb in 2014 and $1.87 in 2015, with today’s copper price at $2.5. Increase in total cost is mainly due to increased depreciation charges, business development and hiring.

$.45c of this is production costs of cathodes, $.16c is mineral extraction tax and around $5m of costs is assumed to be salaries, taking into consideration the Directors are most probably paid in dollars. CAM’s fully absorbed cost of $1.87 implies the copper price has to decrease another 25% for the company to breakeven, excluding any future benefits from the local currency devaluation.

Management states that half of cash costs are in the local currency amounting to around $.32c/lb of costs that will be 70% of 2014 value. This reduces total cash cost to $.55c, a 26% decrease and gives a long run fully absorbed cost of $1.675/lb. This reduction in the cash cost will amount to an expected $5m in cash savings per year for CAM, increasing the dividend cover in the future.

An incident on site that halted production for a short period hurt results slightly in 2015H1. EBITDA margin was down to 53% and net margin in H12015 was down to 33% from 57%. Average sale price p/t was $5,936. A 16% decrease in average sale price resulted in 10% fall in revenue, although the halt in production also affected this.

CAM created $13.3m in cash in H12015. Extrapolating this figure prices CAM trading at 10x cash flow. The cash generated suggests CAM turned 44.3% of sales into cash flow. This cash flow is double the $6m of dividend payments agreed as 20% of revenue to shareholders providing some safety in ensuring investors are paid to hold this company.

How much does the Kounrad mine cost to maintain annually?

Capex is crucial. Operating cash needs to cover the dividend and any maintenance capex.

Estimated $6.5m maintenance capex needed for the Kounrad mine over 3 years is $2.16m per year. Total expansion costs for the mine is $35m of which $9.4m was paid in 2014, leaving $26m left over 3 years amounting to $8.6m. So we can assume around $10m plus growth capex for Copper Bay and any other external issues that arise to sum around $12m max capex per year.

Using a decreased operating margin of 40%, down from a 3-year average of 50%, on extrapolated revenue of $64m (12,000 tonnes at current copper prcies) implies OCF of $26m and FCF of $28.5 assuming D&A of $7m, capex of $14m and change in working cap at the historical average of 15% of revenue. This FCF amounts to around $.26c per share which gives a dividend cover of 1.76x. Summing PV of future FCF at discount rate of 12.5% gives an intrinsic value of $2.5, a 5.4% discount to current price. However, using the average operating margin of 50% gives a value of $3.06.

Return

CAM plan to return at least 20%, 25% in 2015, of the REVENUE from the Kounrad project to shareholders EVERY YEAR. This is a powerful insight on the incentives of management and their plan to continue returning value to shareholders. Estimated dividend yield is around 6.4% and therefore I would revalue CAM when the dividend yield gets revalued to the market average of around 4-4.5%.

H&T Group (HAT LN) - Asymmetric bet on a traditional business

'Money talks' was what my Dad always told me. This come to my mind when analysing the pawnbroking business due to the fact that cash-strapped individuals will always be willing to flog assets to raise short-term cash. Those willing to take advantage of the 'fire-sale' of assets could find opportunity. The demand for alternative credit, and in particular short term loans, is a business that has been around for centuries in one way or another and is likely to remain a stable cash generative business. This led me to H&G Group (HAT LN), one of a few main UK high street pawnbrokers remaining in a rapidly changing industry trading at reasonable valuations.

The Business

The group has four main businesses that are all somewhat integrated:

• Largest UK Pawn broking Business– secured short-term loans on jewellery and gold.
• Retail jewellery
• Third party cheque cashing
• Personal unsecured loans up to £1000

The pawn broking business is a very traditional business having been around since 1800’s. They take gold and jewellery as collateral for providing loans to cash strapped consumers. HAT have 191 high street stores around the UK and have started various other businesses that are synergetic with pawn broking such as selling unredeemed pledges through retail and gold purchasing.

Twenty-five percent of HAT’s total assets are receivables[1]; a majority of what mature within a year, twenty-five percent is inventory[2], gold and jewellery, used for retail and gold scrap upon unsuccessful redemptions. This gives the group a large amount of current assets, which are fairly liquid, and upon a fire sale would not take much of a haircut to the current market value. However, these assets are directly exposed to the price of gold, which has been in a downtrend for a few years and is one reason the company has been out of favour with investors.  

The group accept collateral of a notional value marginally higher than the loans they provide. They claim that this collateral is worth more than the loans provided even at gold prices near 5 year lows today. Therefore, even if customers do not repay the loans, HAT still make a profit as the collateral is of even higher value and can be sold through their retail business. Although the group redeem, on average, 80% of loans, “if the redemption rate decreases by 1%, i.e. the customer defaults on loan, the profits of H&T actually increase by £90,000”[3] at year-end 2014 pledge book values.

The business has suffered in the last 5 years due to a depreciating gold price and new strict regulation on payday loans. New UK regulation in 2013 capping interest on short term unsecured loans led lots of competitors to close down stores and investors dumping shares in companies relating to the business. Price of HAT fell from around £3.5 in 2012 to £1.5 even though personal loans only accounted for 3.9% of gross profit last year. The price is trading below NAVPS of £2.47 and seems to offer a low risk opportunity on any future growth of the business. However, the high margin business of payday loans is over and management is adopting a new business strategy.

Change of Business Strategy

Below shows the change in revenue composition and business mix in the last 8 years. This company has changed its strategy due to new regulation, the increased use of the internet for commodity linked loans and services and more importantly to reduce exposure to gold prices. They have introduced retail in 2008 to diversify their revenue stream and this has proved a success growing to around 30% of total revenue today.

They have reduced net debt considerably with D/E decreasing from over 40% in 2008 to around 19.5% today. Management claimed in 2014 that they’re concentrating on ‘developing new profitable products in the retail shops’ to boost revenue. HAT has rebranded their retail business and retail sales have a CAGR of 9.5% over the last 5 years and grew 25% last year.

The market is still partially valuing an old business with no potential growth. These future earnings streams do not have to be large for this company to outperform the current implied growth rates by the market. Not much capex is required to roll out the new business plan. They mainly lease their high street stores and space so just branding and marketing the retail business is necessary expenditure in the next 2 years. 

Management and Financials

CEO is ex RAF – he pledged to decrease net debt by 50% in 2013, delivered 54% and then reduced it in 2015H1 further by 34%. Seems very regimented in cost control, which is a key factor for changing business mix efficiently.

Margins are depressed and far below their 5-year average of 15% and 10% for operating and net income margin respectively. Today they are trading at 7% and 5% today due to the natural low margins of a more retail based business. ROE, ROA and ROC have all decreased as the business mix shifts more to retail and therefore future growth is now determined by sales growth and asset efficiency. 

The balance sheet is strong. They have halved net debt in 2 years to a D/E ratio of 19%, interest coverage ratio is sufficient at 12x and the company is £16m drawn on a £50m debt facility at 125bps above LIBOR. HAT has compounded book value at 18.56% a year over the last 10 years showing how prudent management are at managing the balance sheet and creating value. The Altman-Z score – a measure of the likelihood of bankruptcy within 2 years - of HAT is 4.21 is considered far from in distress (anything above 2.6 is considered safe).

FCF is very high relative to comparables and has been positive and increasing since 2011 even though the industry has been struggling and business mix changing. The FCF yield is currently around 16% and has been consistently above 10% for the last 10 years.

Risks

The main risk of this business is the dynamics of the business itself, the supply and demand of alternative credit. This is somewhat cyclical although the competitive landscape of the pawnbroking business ensures that when demand returns, HAT are in the position to gain market share.  The price of gold has proven to have little risk to the underlying performance of HAT as they do not lend too much at such high prices. An external risk is the use of Internet taking the service away that pawnbroking retail shops provide although H&T and cash converters are still around dominating the high street pawn broking market today.

Catalysts/Unlocking of value

The market is pricing a company in a dying industry with virtually no future growth. The gold price is at a 5-year low and HAT is still showing a healthy FCF yield and profit. Potential catalysts come mainly from two sources, growth in revenue from the retail segment or an increase in the underlying gold price. Price will follow as earnings grow upon potential:

• Improvement in the dynamics of the core pawnbroking business
• Increase in gold price
• Success of new retail revenue stream

Valuation

Rearranging P/B = (ROE – g) / (re – g) from the current P/B ratio of 0.8 and using the new lower 5% ROE shows the markets implied earnings growth rate of 1.4%. The company consistently retains earnings and looks to reinvest in the company. The 5-year average dividend pay-out ratio is 16.75% and therefore with the fundamental growth rate in earnings g = b*roe, using HAT’s new lower ROE of around 5% gives an average fundamental EPS growth rate of 4.16%.

The FCF/mkt cap has been consistently over 10% for the last 5 years. The business does not require the expenditure to purchase and roll out new stores it has in the past and therefore future capex will be lower. Capex per share was around 20p in 2012 and 2013 although last year, and after recent 2015H1 results, capex per share is now around 4p or 2% of revenue. OCF in 2015H1 was slightly lower than in the past due to increasing inventories (although management claim this stock will be cleared in H2) and therefore FCF was 24p per share. This prices HAT at around 8.25x FCF.

Discounting FCF at a 10% cost of equity gives a price target of around £2.4. Regardless of technical valuation I think this offers a low risk opportunity to benefit from any pick up in a traditional business, with liquid assets as protection, plus a cheap option on any future gold price appreciation.

This analysis was wrote on 20/08/15. 

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[1] All receivables on balance sheet are stated at nominal value as reduced by appropriate allowances for estimated irrecoverable amounts

[2] Inventories stored for re-sale are stated at the lower of cost and net realisable value which is valued at spot gold prices.
[3] Annual Report 2014 

So here it goes...

The aim of this blog is to rationalise my thinking towards investing, learning and other disciplines that can improve my thinking. I find that writing helps to improve my understanding and find flaws in my thinking on all topics, especially investment ideas. I like analysing stocks, searching for value and understanding businesses. My aim is to not lose money and have some fun on the way.

I am looking to share ideas and learn off investment professionals, like-minded learners and thinkers. Attempting to put into practice the wisdom of Munger, Buffett and other Graham disciples who have evidence-based results within investment. I particularly look at small, underperforming companies on one end and look to buy high quality compounders at the other end of the spectrum. I am looking to learn and therefore appreciate any comments to improve my thinking.

Equity analyst, economist graduate and, (apparently), master of Investment Management by degree too. I am by no means a natural born investor or genius, just trying to end each day that little bit smarter.