FTSE Market Valuation – August 2017

Introduction

It seems the high market valuations we’re seeing at this present time is the du jour thing to be commenting on these days. I am sure many are sick to the teeth of such speculation, if you are one of these people, feel free to stop reading. Honestly, I wouldn’t blame you. 

Valuing the FTSE Today

In terms of valuation, one of the most common metrics that’s used is the overall stock market value (in the case of the UK, the FTSE All-Share) to GDP. The below graph is a little out of date, but the latest figures (end of June 2017) I have is that the current ratio is at 124%. Indeed, the market is up quite a bit from the data snapshot I used, so it’s easily possible that we’re starting to approach highs not seen since the Dot-Com crash. On this basis, the market is very expensive.

The next graph shows the FTSE CAPE ratio’s for various sectors. When you strip out materials and energy, the ratio’s tend to bunch between high teens and low twenties. This would suggest to me that these utilities, industrial, and financial sectors are expensive, but certainly not in a bubble.

The interesting graph that I have split out by itself is the much in vogue consumer staples sector. I don’t have the raw data, but the current CAPE looks like it’s at about 26, I would regard this as very expensive, but I would stop short at calling it a bubble. When looking at companies in this sector, the ratio certainly bears out with what I am seeing when I am looking for value in (i.e. there isn’t much!). Unsurprisingly, I don’t have a single consumer staples business in my portfolio.

One of the things you’ll probably have noticed, is that I haven’t commented on the valuation of the energy/materials sector. This is quite deliberate, as frankly I am appalled at the behaviour of some of the large/mega cap companies that are operating in this sphere. Selling off assets in a bear market and taking on debt while bleeding free cash flow, just to maintain (and even increase) the dividend strikes me as reckless. The oil and metals market may certainly turn at some point, but the question I would have to ask is, what if it doesn’t turn quickly enough? It won’t happen this year, or probably the next. But as long as commodity prices remain low, the risk increases that we see a liquidity crunch develop. If that happens, it would be catastrophic for the Royal Dutch Shell and Rio Tinto’s of this world, as any subsequent dividend cut would collapse share prices as income focused investors stampede out of these shares. Don’t get me wrong, this is not a prediction. However, I do think it’s a risk that has been all too easily dismissed by investors.

Conclusion

The market is dear, going into the detail though, certain sectors are more expensive than others. As I am a horrific market timer, the best strategy for me is to invest little and often; to find companies in neglected/undervalued sectors and look for a reversion to mean.

United Carpets Group – July 2017

United Carpets Group – LON:UCG
Share Price – £0.0945
Market cap – £7.7m

Introduction

This franchiser of carpet and bed retailing outlets first came into existence back in 1997 when founded by husband and wife team, Paul Eyre and Deborah Grayson. However it wasn’t until 2005 that the company sought a listing on AIM, which according to the IPO document, suggested that the funds raised were to be used in an ambitious expansion campaign. The company then embarked on that growth plan at just about the worst possible moment, going from operating 51 stores in 2005 to a peak of 85 stores in March 2011. Unsurprisingly and in the grip of the 2007 financial crash, the company fell into difficulty. Presumably having lots of new and unproven stores where trading collapsed, combined with leasing arrangements that were signed into during boom times would put the company on a very precarious footing. Indeed trading was so difficult, the company was actually forced into pre-packaged administration for awhile, even being de-listed from AIM for a period of time. Quite remarkably though the company emerged a smaller, more leaner operation, with a lot of the onerous leases and commitments discarded. Since the pre-pack, the company has cut the number of stores further, going from 67 to 57 as of the most recent annual report. Usually a shrinking retail footprint would be of concern to me, but in this case, increased profits and LFL sales suggest management have been quite astute in closing non-performing stores.

With all that said, it’s very hard to get away from the fact that this company only recently well into administration. Usually, this is the sort of thing to pass on a company. In most cases, companies that are forced into administration, do so because they are inherently poor businesses. In this situation, I think there are extenuating circumstances.

  1. Both founders remain at the company from 2005 to this day, with Paul Eyre having never sold a single share, and partner Deborah Grayson’s actually increasing her stake slightly through the years. Indeed, the actions of this management team during the 2011 crisis, where their super-human efforts kept the company in public ownership certainly suggests to me proper alignment of their interests with minority shareholders (who could easily have been shafted).
  2. The fully diluted share count has remained almost entirely static over the entire period the company has traded on the public market. What’s key for me is that no new share capital needed to be issued during the 2011 crisis. Owner operators who believe in the businesses they run are usually loathe to issue shares, and this appears to be the case with United Carpets.
  3. The aftermath of the 2007 financial crash appears to have put paid to the expansion plans. Certainly, the market appears to have taken a dim view of this, but is the lack of growth really such an awful thing? In a difficult retail environment, an owner operator might be content with retrenching and running a smaller, but more profitable operation. It appears to me that management have learned the lesson of their brush with near-death in 2011 and are not eager to repeat the mistake.

Valuation

Now that I am reasonably comfortable with the business, what do I value it at?

United Carpets Group historical income statement

United Carpets Group historical balance sheet

In terms of a tradition EV/EBITDA ratio, we have the following.

  • Enterprise value: £5.9m (after deducting £820k from the current cash total of £2.6m for the special 1p dividend)
  • EBITDA: £1.75m
  • EV/EBITDA: 3.4x

On a traditional P/E ratio, we have the following

  • Price: 9.45p
  • Earnings: 1.57p
  • P/E: 6x

Looking at the share price, the market perception is that this is a company going nowhere. While income is only up slightly over the past four years (13% cumulative), shareholders equity has gone up 300% in the last six years. It gets better than that. In the last three years, over £2.4m of dividends have been paid out as well (I am including the recently announced, but as of yet unpaid 0.28p final dividend). If future dividend payouts are anything like we’ve seen in the past, then based on the current market cap I have bought at, I should see 1/3rd of my investment returned in dividends alone in three years. While that remains to be seen, it’s clear this company is a huge cash generator and has been unfairly ignored by the market.

Conclusion

This is a tiny company where most of the shares are tightly held by the majority holders. Worse yet, on paper it looks like it’s going nowhere and operates in a sector that’s universally hated in the market. When you scratch beneath the surface on this one, you can’t help but be impressed. Firstly, you need to consider that the company operates in a depressed retail sector, where competition is brutal. If it can generate the returns it does in such a hellish environment, then there is potential for a substantial re-rating of this share in a more favourable consumer environment. I have no idea when that day will come, but until them, I am happy to enjoy my dividend and hefty 17% earnings yield.

I hold shares in the aforementioned share.

LXB Retail Properties – July 2017

LXB Retail Properties – LON:LXB
Share Price – £0.315
Market cap – £53m

Introduction

This is the second special situation share I have been involved with. For posterity, I would like to direct readers to my first, which ended in me taking a small loss due to not having the stomach to wait out a takeover of a failing electronics company. While I believe the investment thesis for this company is much stronger than my failed Sepura investment, I do want to explicitly mention that I have gotten this sort of thing wrong in the past.

With the pre-amble out of the way, the company in question is LXB Retail, a British property company (mostly UK commercial) that is currently liquidating (voted on by shareholders and well under way); which I believe contains significant upside that may be realised within a very short time frame. Management have already returned the majority of NAV, and we’re now in the final innings with regard to the final distributions. I believe management are trustworthy and will do the right thing (Chairman Phil Wrigley is well-known and an experienced executive) and all actions by the company thus far have indicated as such.

Value

If we can accept that management will do the right thing, naturally readers will be asking, where is the value? Indeed, if you look at the most recent interim, it suggests minimal value over stated NAV (33.7p) will be realised as the current share price trades at just a shave under that at 31.25p.

I believe that stated NAV is an incorrect approximation for what shareholders should realise. If one reads through all the shareholder communications, it’s quite clear that significant value above NAV remains unrealised. In the Chairman’s letters to shareholders, he has consistently and quite explicitly stated this, specifically pointing to the company’s still under development Rushden Lakes project as an example of an asset being carried at less than true value.

Rushden Lakes

The Rushden Lakes project is the major remaining commercial development that is still ongoing for the company. Phase 1 is in the final stages of completion (retail and restaurants) while planning permission for Phases 2 and 3 (cinema, leisure developments and restaurants) has been approved (although currently under review by the Secretary of State, but not expected to be blocked). The company describes this project in further detail on its website. While the company no long owns the development (On May 2016, LXB sold this development to The Crown Estate) they are still responsible for managing the development and letting of the project. Naturally, the £65m sale price agreed for the development isn’t be the final consideration, as each stage attains full planning permission, and a certain amount of the property is pre-let, additional cash payments are triggered. With phases 2 and 3 now almost entirely at the thresholds required to be fully pre-let and unconditionally planning approved, the final cash payments should soon be triggered.

April 2015

The initial and potential future proceeds (net of funding costs and excluding any potential further receipts for the second and third phases at Rushden Lakes) which will result from these transactions are expected to be approximately £150m of which £68.7m will be received by mid-May 2015. The transactions are also anticipated to deliver an additional NAV uplift of approximately £37m over and above the values reflected in the September 2014 balance sheet. This accretion to NAV is expected to be realised in the Group’s results over the next two financial years.

June 2016

I should also comment on ultimate value. It is impossible to provide a forecast of what the end NAV in the portfolio will be as it is dependent on the outcome of a number of incomplete projects, some of which are subject to some material uncertainties which are still to be resolved, and now within a much reduced timescale. Notwithstanding those challenges, we remain confident that the end value for Shareholders will exceed the 64.18p per share referred to above by a comfortable margin. (18p dividend has been paid out since then, also 12.5p lost due to delays and cost overruns)

March 2017

Your Board and the Investment Manager are committed to completing the proposals as quickly as possible. As and when lettings are completed and/or sales made we will review the possibility of returning further cash before any final proposals are put to Shareholders, and we look forward to the confirmation of the planning for Phases 2 and 3 at Rushden Lakes which will have a material impact bearing in mind the current NAV.

June 2017

“In my Chairman’s statement dated 21 November 2016 I said that;
“The amount of ultimate value realisation is heavily dependent on the grant of planning and a legal agreement with The Crown Estate at Rushden Lakes and a successful sale of Stafford Riverside, but your Board remains confident that the final figure will be in excess of the NAV reported today” The NAV at that date was 38.7p per share, as adjusted for a further return of capital. Today’s announcement brings a successful conclusion to the sale of Rushden Lakes Phase 2 a little nearer and whilst the caveats set out in my statement of 21 November 2016 remain, the Board has no reason to believe that in excess of the NAV of 38.7 p per share is an unrealistic aim.”

Valuation

In the April 2015 note, a total possible NAV uplift for all three phases of the Rushden project was pegged at £37m. £19.5m of that uplift was booked for the closing of Phase 1, which would suggest that a possible £17.5m remains on the closing of Phase 2 and 3, or about 10.4p per share. The 10.4p of remaining uplift combined with 33.7p of current NAV, suggests a final return of 41.1p, which would tie in with the most recent management statement of a return “in excess of 38.7p per share”. Assuming that Phases 2 and 3 of the Rushden project are finally approved at the end of August (management guidelines), at that point the 10.4p can be booked, giving me a return of up to 30%.

Of course, the worst case scenario is that the Secretary of State overrules the planning decision for Phases 2 and 3 of Rushden. In that case, no uplift in NAV is realised, but at since the company already trade at a discount, a possible loss on the downside should be minimal. Another risk is further delays and cost overruns, I hope this is unlikely, given that the additional works that Phases 2 and 3 of Rushden that were required have now been all put in place.

Portfolio Update – 2017 Mid-Year

I have been considering quarterly updates, but given the lack of activity in my portfolio over the last six months (and a lack of time on my part), I have decided to provide a bi-yearly update instead.

2017 mid-end performance: 4.7%

With regard to activity over the past 6 months, I sold nothing, but did use some new money to initiate three new positions. Two of those positions I discussed on the blog (Admiral Group and M Winkworth), and the other was an exercise in bottom-fishing that I haven’t had the time to write up yet (Tasty Plc).

  • Barclays, my largest position, delivered results for 2016 end-year as I would have hoped for, maybe even exceeding my expectations slightly. However, given the rapid turnaround that has taken place, I was still a little disappointed in other respects. In particular, the surprise “exceptional” write-down of the Barclays Africa operation indicated business as usual for bank that has had a string of these “exceptional” write-down’s for the best part of a decade. I still think that Barclays own a collection of high quality businesses, but with most of the restructuring now complete, there should be no excuses in 2017 to not see vastly better results.
  • Admiral Group is a position I initiated at the start of the year and knowing my luck, the share price tumbled a few weeks after I bought it when the government announced measures that would require the company to increase the cost of claims paid out. Thanks to excellent year-end results (notwithstanding government measures) and dividends paid out, my position on this is already in the black. I feel comfortable with my position in this company.
  • M Winkworth is a new position I opened up over the past 6 months. I have to say, this is a company that has given me some concern, despite it generating a 15% return on my cost basis. Up and coming competitors in the estate agent business have been taking significant market share from established bricks and mortar operations like M Winkworth. I do not know how houses will be bought and sold in the future, but if results here continue to slide, then I am minded to just cut this position entirely.
  • Vienna Insurance Group has just been a pleasure to own. I bought this at significantly below tangible book value when it reported problems (critically, not with underwriting). While low interest rates have impaired returns on their investment portfolio, underwriting has remained strong with the business continuing to report a combined ratio well under 100%. This business still has exposure to Eastern European markets which I am wary of, but overall my expectations have been exceeded and the company has given guidance of superior profits to come in 2017.
  • Wells Fargo was a share I was lucky enough to buy at close to a multi-year low after the fallout of the “fake accounts” crisis that it was dealing with at the time. 2016 year-end results were a little weaker than I hoped for, also a gradual decline in ROE and rising costs have given me minor cause for concern. This is a company I will be keeping an eye on in case it displays any further weakness.
  • Tasty is still a very new share in the portfolio, hopefully I will get time to write it up in further detail.

Up to date information on my portfolio can be found here.

An Open Letter to Barclays Management

Dear Mr. Staley, & Mr. McFarlane,

Firstly, I would like to congratulate the bank on the recent results reported for year-end 2016, and Q1 2017. The transformation we’ve seen at Barclays in such a short time-frame from when Mr. Staley took the CEO position in October 2015 has been most satisfactory. While significant challenges remain ahead, we are now on a clear path towards high quality and sustainable earnings. For that I feel that you must be commended for your efforts. However, I am not writing this letter solely to congratulate the team on this, I am writing as an individual shareholder with a specific view on capital allocation going forward.

I noted with particular interest that the Terms of Separation with Barclays Africa had been signed on the 31st of May 2017. I feel that this marks a watershed moment for Mr. Staley and  the current management team. Not only does it signal the de-consolidation of Barclays Africa from the Barclays balance sheet, but it also raises the CET1 capital ratio well in excess of the target set down in 2016. If my understanding of the present situation is correct, then the de-consolidation of the African business now puts Barclays within the 13.2%-13.3% range of CET1 capital ratio, well in excess of the 12.3%-12.8% range specified as required by Mr. Staley in March 2016. I believe the opportunity now exists to shrewdly use this extra capital to generate an outstanding return for shareholders.

“Any management of a bank that is trading below its book value can’t sleep at night,”

Mr. Staley made the above statement on March of 2016, and while it is true that the differential between the share price and book value has closed somewhat since this comment was made, it remains and is still significant. As I write this letter, the Barclays share price stands at £2.11 (June 2nd 2017 close), a discount of just under 28% to tangible book value of £2.92. I certainly recognise management’s priority isn’t with the short-term fluctuations of the share price. However, I do think in certain circumstances, questions must be asked when such a clear discount persists over an extended period of time, as is the case with Barclays. Clearly the market is signalling only one outcome here; namely that Barclays is a mediocre business, and thus deserving of such a discount. If you are to believe as I do that this is not the case, that Barclays will have a future that is more glorious than its recent past, then now is the time to consider how we can maximise our investment today in order to deliver a superior return tomorrow. I feel that with some excess capital now available, a compelling opportunity now presents itself.

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.

Warren Buffett wrote the above in his 1984 letter to Berkshire Hathaway shareholders and I believe what he wrote couldn’t be more true for Barclays at this moment of time. With our bank now trading at a significant discount to tangible book, a stock repurchase plan now looks incredibly accretive to investors on a per-share basis.

As of the last Q1 2017 report, Barclays reported the following numbers.

  • RWA £361bn
  • CET1 ratio 12.5%
  • Share count 17.03bn

If we were to propose a stock buy-back of 850m shares and acquired them at the current £2.11 stock price, I estimate the numbers end up as below.

  • RWA £340bn
  • CET1 ratio 12.8%
  • Share count 16.2bn

As you can see CET1 ratio stays at the upper-end of management’s guidelines. However, book value and earnings per share increases in an accretive manner to shareholders, thanks to the fact we are purchasing well below book value. As the bank grows into the future, returns should compound as the growing numerator of earnings will be upon a shrunken denominator that is the share count.

Last year you took the brave step in cutting the dividend last year because you knew it was the cheapest way of raising capital and generating long-term shareholder returns. Going forward, as we start to create surplus capital on the balance sheet, I would urge you to consider the benefits of a stock buy-back, particularly while it trades below tangible book value.

Kind regards,
Tabhair.

Premier Diversified Holdings – June 2017

Premier Diversified Holdings – CNSX:PDH
Share Price – $0.125 (all figures quoted in $CAN)
Market cap – $18.5mn

Introduction

Premier Diversified Holdings (formerly Premier Diagnostic Health Services) is a Canadian company that was brought under the control of Sanjeev Parsad in 2014 (he now holds about 1/3 of outstanding stock) after it was brought close to bankruptcy while under previous management. The original business was to provide medical diagnostic services (MRI/CT scans) to patients in two locations (China and Canada). Since 2014 when Sanjeev took charge, the company has raised capital numerous times, closed the Chinese diagnostic centre, and is now a diversified holding company. Despite having a tiny market cap, the stock has gained somewhat of a cult following amongst value investors as Sanjeev is the owner of the popular investing bulletin board, Corner of Berkshire and Fairfax. For those that are interested, a further discussion on PDH is maintained on the forum itself.

Analysis

There’s essentially two parts to the PDH story.

  1. The revenue producing part (the medical diagnostics business at Burnaby and China)
  2. Investments (marketable securities, Sequant Re, Go eVisit, Russell Breweries, and real estate)

Revenue – Diagnostic Clinics

The revenue generating part of the business now consists solely of the Burnaby clinic (the China operation is now closed). For quite some time, the medical diagnostics business has been a problem child for PDH and on initial inspection of PDH’s most recent financials things still don’t look great. Looking at the six month period ending March 31st 2017, the income statement shows operating losses for this business at -$268k for the period (this is before central corporate costs).

Over the long-term, the picture doesn’t look much better for the year end numbers of 2015 and 2016.

Management do seem confident that business will pick up, and the slide from the 2017 AGM deck certainly suggests that operational gearing exists in the business and thanks to high margins, any new business should see a significant drop through to the bottom line.

For me though, the jury is definitely out. We have 6 years of financial data for the business now, and in each year it has generated operating losses. I am certainly no expert in the field of medical diagnostics, but based on past history, it would seem to me that a Herculean effort would be required to get the remaining half of the business cash flow positive. Then there’s the concern that expensive CT/MRI machines need to be replaced. A quick search of Google suggests $1M is a typical enough price for an MRI machine with a lifespan of 10 years. Note that PDH’s machines were bought in 2010, so it would seem at some stage in the not too distant future that they will need replacing.

One final point on the diagnostics business I have not covered. The assets of the closed down Chinese clinic are now carried on the books at marginal value. It seems unlikely that the business in this jurisdiction can be restarted (why would it have been closed down otherwise?), but perhaps a fully functioning, and well equipped diagnostics clinic ready to go could be sold in excess of carried value on the balance sheet? Management have certainly suggested booked asset values at clinics are far below real value.

Investments

Since Sanjeev has taken charge, PDH have entered into a variety of other investments.

  • Sequant Re
  • Russell Breweries
  • Kingswood Asset Management
  • Go eVisit
  • Marketable securities

Sequant Re is PDH’s largest investment to date, and unfortunately for me, I don’t understand it in the slightest! There’s a description of what Sequant Re are offering here. In short, it sounds like Sequant are looking to get into the business of matching re-insurers who wish to collateralise and sell parts of their book to outside investors who wish to either gain exposure to a specific type of insurance risk, or merely seek a given return on their capital. What sort of fees are generated, capital requirements, or fixed costs are needed is completely unknown. All we know is that 5,326,000 are held and carried on the books at $2.27mn.

Russell Breweries

This is perhaps the easiest investment to evaluate. PDH own 15,256,000 shares (or 17.52%) in Russell Breweries, a listed Canadian brewer that is carried at $1.067mn. The company is currently in the process of being sold off with the proceeds being distributed to shareholders. It’s clear that this carrying value is far too conservative. I estimate the actual value as follows.

  • $726.8k cash already received ($0.05 initial distribution x 15.256mn shares)
  • $738.2k final liquidation value (remaining equity – minus $200k liquidating costs)

Total value of $1.465mn. Essentially, I would be expecting a gain of about $400k over stated book value.

Kingswood Asset Management

PDH have also combined with Kingswood Asset Management, entering into a partnership to build residential property in Vancouver and its suburbs.

  • $375k invested in Bentley in 2015
  • $500k invested in Acora in 2016

Management have stated “Sale price per square foot presently is significantly higher than original projections when we initially looked at the investment’s potential”, so it looks like they should be well in the money on their $875k investment, assuming Vancouver prices don’t fall in the meanwhile.

GoeVisit

PDH also own just under 30% of an online portal called GoeVisit, which is an online pharmacy that provides free consultations with a physician or nurse. They can diagnose up to thirty conditions and then prescribe medicines, which GoeVisit can then dispense, which presumably is where the revenue in the business is. As of the latest interim statement, $650k has been spent on the stake in this business with no revenue/profit figures yet provided.

Marketable Securities

All the marketable securities have been sold.

Sum of the Parts Valuation

Baseline valuation

  • Burnaby/China Diagnostics: $2.0mn (assuming only 20% depreciation of equipment values)
  • Sequant Re: $2.27mn
  • Russell Breweries: $1.45mn
  • Kingswood: $1.05mn (assuming a 20% return)
  • GoeVisit: $650k
  • Current assets – liabilities: -$100k

Total value: $7.32mn or $0.05 a share

Aggressive valuation

  • Burnaby/China Diagnostics: $2.5mn (assuming no depreciation of equipment values)
  • Sequant Re: $3.4mn (assume 50% increase in value)
  • Russell Breweries: $1.45mn
  • Kingswood: $1.3mn (assuming a 50% return)
  • GoeVisit: $975k (assume 50% increase in value)
  • Current assets – liabilities: -$100k

Total value: $9.52mn or $0.065 a share

Conclusion

On a sum of the parts assets basis, even my most aggressive valuation of the company is still only half the current market value. The other thing that’s concerning here is the high corporate expenses. Management have done well in getting them down, but the run-rate is still currently just under $1mn a year. Going from here, management have got to be exceptional if they’re going to overcome this hurdle so value can accrue to shareholders.

I won’t be investing at the current price, but I will be enthusiastically rooting for Sanjeev and the team.

 

Purplebricks Group – May 2017

  • Purplebricks Group – LON:PURP
    Share Price – 348p
    Market cap – £944mn

Introduction

As an owner of M Winkworth, I have been keeping a close eye on the competition in the estate agent business. For the most part, operators with the traditional High Street presence (Countrywide, Foxtons, M Winkworth, etc.) have struggled in the last year as a slowdown in the economy, stamp duty changes, and Brexit have all taken a toll in a market that may just have boiled over. Despite the slump in market activity and several profit warnings for the bricks and mortar operations; up and coming internet-only providers like Purplebricks have grown market share and seen their shares soar. With the share price up 3.5x from flotation only a year and a half ago, and with the traditional estate agents down about 50% – the market has taken a dim view on the future of M Winkworth, Foxtons, etc.

Clearly, a bet on M Winkworth in this market is clearly a variant perception and when taking this sort of position on the market, extra due diligence must be made.

Analysis

Since Purplebricks truly is a start up, any meaningful analysis of the financials is going to be guess work to a large extent. We do have 2.5 years of results to examine (please note the 2017 numbers are from the recent interim).

The current broker forecast for full-year revenue for 2017 is at £42m and the most recent trading statement has suggested that they will beat that (of course they are going to beat their own forecasts). Looking at the most recent trading update, the company has said it expected to deliver positive adjusted EBITDA for the full year results.

As a result the UK business is expected to record an adjusted EBITDA profit for the full year, building on the UK’s £0.3m reported adjusted EBITDA in the first half.

This is interesting because it seems as the business scales up, it is still unable to deliver positive EBITDA, despite now having a meaningful share of the UK market (I estimate about 4%). I am sure the bullish argument will be that they are investing in marketing and building the brand. However, given the nature of the property sales business, it’s not sticky revenue that can be kept with a one-off spend on advertising. People only buy and sell property a few times in their lifetime, therefore Purplebricks will need to maintain their high adverting and marketing budget in perpetuity in order to retain market share.

Red Flags

There are a number of other red flags that go beyond the underlying financials.

Insiders have recently sold a substantial amount of stock.

The CFO has resigned recently after only being at the company for two years.

Purplebricks Group plc (‘Purplebricks’ or ‘the Company’) announces that Neil Cartwright, Chief Financial Officer, is to step down from the Board and will leave the Company due to ill health.

No profits now, nor likely this year. Heavy insider selling. A sky high valuation. A CFO resignation. Yet my strangest observation is yet to come.

The Curious Case of Their TrustPilot Review Centre

I noticed in their recent trading update for full year 2017, the company made mention of their excellent TrustPilot review scores.

Mentioning TrustPilot is actually something that they have done consistently in their trading updates, so naturally I was drawn to investigate this. I noticed a some strange anomalies.

Firstly, I was surprised at the sheer size of the volume of reviews that Purplebricks had received. To investigate the data in better detail (rather than having to manually wade through 900+ pages) – I wrote a small computer program that pulled the data.

The volume of reviews has increased as time has went by (you’d expect this as sales have increased). What does seem strange is just how many reviews are being generated. If we are led to believe that Purplebricks are doing about 5,000 instructions a month (their word for putting a property up for sale), then roughly 1/4 to 1/3 of customers are then going onto TrustPilot to give the company rave reviews. I find it a little unusual that people would get excited enough to do this for an estate agent.

Perhaps they get an incentive to post about their experience?

I dug deeper into the content of the reviews to see what else came up.

As you can see, I did not have to go far at all to find an oddity (the very first page of reviews entered today). A number of consecutive “5 star” reviews (this is the number in the third column) with the phrase “excellent service” consistently reproduced in the title of the review. Is the “excellent” adjective really so common really so common to be found on review sites, or did the data entry monkey just get bored?

Ordinarily, I don’t give much credence to online reviews in real life, and certainly not in investing as they have become mostly worthless for many reasons (lots of studies on Google around this). However, the interesting thing here is that management of Purplebricks have repeatedly drawn investors towards their excellent TrustPilot scores in their trading updates (here and here). Ignoring the fact that TrustPilot reviews have no place whatsoever on a trading update for a £1b company, the strange circumstances in which they seem to have been created certainly raises questions in my mind about this company.

Full disclosure – No position in Purplebricks. If anyone is interested in my dataset, I can make it available.

Fevertree Drinks – May 2017

Fever Tree Drinks – LON:FEVR
Share Price – 1660p
Market cap – £1.91bn

In my last post about Admiral Group, I talked a little about trying to broaden my investing horizon to consider quality growth companies, as well as traditional value stocks. With value stocks performing so badly since the financial crisis of 2008, it does seem like investors should make room in their portfolio’s for decent quality growth businesses that don’t command too high a multiple. This has led me to consider all sort of companies I would have not even considered before, and hence why I am writing about Fevertree Drinks today.

Introduction

fevertree share price

Fevertree is one of these stocks that pops up frequently on my Twitter feed. Usually, with this type of company, I take a look at the PE (currently 70) and just pass completely on it. Today, I decided to take a more in-depth look as this is a stock that has just went up and up, perhaps I should be looking, maybe there is more growth to come, even after the 9-fold increase it has seen since IPO in late 2014?

Analysis

Since I didn’t want to be influenced by opinions, I went straight to the numbers.

fevertree financials

The first thing that stands out is revenue. Usually as a company grows, the growth rate itself declines as the company takes market share. This however is not the case with Fevertree, which has seen an increase in the growth rate for five consecutive years. It’s clear that this company is riding the crest of a wave that’s based on the booming gin sales that we’ve seen in the last few years. Impressively, operating margins have also expanded, with them now out to 33.6% for the year end 2016. Equally, free cash flow has also ballooned, doubling for the last two years and now at £20M. This blow-out is not at all surprising given that the business have completely outsourced production and hence have barely any capital expenditure. With that said, it stands to reason that ROIC and ROE figures also stack up quite well.

Having researched the British beverage companies (A.G. Barr, Nichols) and some of the US companies (Coca-Cola, Dr Pepper Snapple, National Beverage Co.) – there was not one competitor I could find with business economics as good. Naturally, you want a company to be well run, but when companies are running the kind of profits that Fevertree are doing, this leads to competition. More on that later though.

Valuation

This is where we get to the nub of the issue. As a business, it’s very hard to pick any holes in this one. This is a great quality business with excellent business economics, management are owner operators who understand their market and have driven outstanding overseas growth. You really could not ask for more.

The problem is the valuation. Price/free cash flow is an eye-watering 95x, price/earnings is 70x, price/sales is 20x. All conceivable valuations that I see on this company place it at a Dot-Com valuation, albeit, a high quality Dot-Com along the lines of Cisco. During the boom times of 1999, Cisco too had a price/free cash flow rating over 100, but yet today, nearly 20 years later, their valuation is still quite some way off meeting that valuation.

Perhaps Fevertree Drinks is in New Paradigm mode. Perhaps management can continue to grow the company explosively by expanding into other segments of the premium beverage market. For me though, this is an easy pass. I think competitors have been asleep at the wheel and I don’t think it’ll be long until Fevertree see significant competition and compression of their incredible 33% profit margins. Also, I am troubled by the lack of history that the company has. As I stated earlier, the growth in the gin market is well documented and has contributed massively to the spike of Fevertree’s revenue. Who is to say that next year fickle consumers may move onto other beverages? Not only that, but the market for premium gin mixers is only so big – at what point does the growth begin to peter out?

One final point before I sign off. Today Fevertree put out a trading update saying that trading will be “comfortably ahead of current market expectations”. I see the share price fell from current all-time high by 2.5%. Many investors were left scratching their heads, how could the share price fall if trading is ahead of expectations?

We all know that here in London, broker analysts get their guidance from the company itself. Interestingly, revenue from both brokers is in the £120M-£130M range. In other words, according to the company, growth will be at best 30%. This troubles me as the range of guidance is just ridiculously low considering the company grew at 70%+ next year. The cynic in me says that the company have deliberately put out such low guidance exactly so they can give the market the usual reassurance that they are surpassing expectations. Perhaps the fall in the share price today was a reaction to that?

Admiral Group – New Holding

Admiral Group – LON:ADM
Share Price – 1987p
Market cap – £5.65bn

The inclusion of Admiral Group in my portfolio has marked something of a watershed moment for me, and it’s something that I hope I don’t regret. I say this, because in terms of valuation, Admiral Group is easily the most expensive stock I have bought on a price/earnings, or a price/book value basis that I have owned. However, I do feel that the premium attached to Admiral is justified by an experienced management team that have run the business in an exemplary fashion while still only scratching the surface of future international growth.

Quality Underwriting

Admiral Group are P&C insurer based in the UK that operates both in the domestic market, and internationally. They primarily derive their profits from their well established and mature UK motor insurance business. This part of the business has delivered outstanding returns, due to the industry leading underwriting standards that they have set, combined with an exceptionally low expense rate and extremely conservative releasing standards when compared to any other competitors. For those not familiar with the insurance industry, when evaluating the quality of underwriting, I find the two best metrics to determine this are the combined ratio and reserve releasing/strengthening.

The most recent investor presentation only presents a trailing 10 year history of expense, combined ratio’s, and reserving, but if you were to go back to 2000, you will find will find the the overall trend towards out-performance remains strong in these areas.

Growth

I’ve demonstrated the quality of the underwriting, but what about growth prospects? Well, the potential runway here has the potential to go on for quite some time yet. For a start, Admiral only have a 13% market share in their core UK market. Clearly there is still an opportunity for growth in the core, extremely profitable market. It gets better though. In recent years, Admiral have taken their unique and wildly successful insurance model and have exported it abroad to other jurisdictions in the US, Spain, France, and Italy. Building up these markets from scratch has not been easy, indeed Admiral have sustained early losses. However as they have built up scale in markets abroad, losses have started to recede, and in some instances break even numbers have been reported. Positive numbers from the international operations will not come over night (or even in the next year). However, I think this provides opportunity to the long-term investor, and with such a proven model and management team in place, I think it would be a mistake to write-off the success of this venture.

Outstanding Track Record

Returning to the overall numbers, please don’t take it from me though, you only need to look at the previous 10 years of financial results to see just how outstanding the business has performed.

With such an outstanding track record, I feel that despite a high valuation, the opportunity with Admiral I still compelling for a long-term, buy and hold investors and have initiated a position.

Sepura PLC – Position Closed

Sepura PLC – LON:SEPU
Share Price – 15.5p
Market cap – £57.5mn

Anyone who is eagle-eyed and has been monitoring my portfolio would have spotted that I took a position in Sepura a few weeks back. Almost as soon as the position was opened and I finally got a chance to blog about it, it was closed resulting in an 11% loss including costs. Needless to say, I was deservedly punished for my hubris, and will recount the lessons here.

Introduction

Sepura, the maker of professional radio equipment was once a high-flyer in the small cap world. From the depths of the recession in 2008, it had been growing consistently, increasing profits and generating dividends for shareholders. As you can clearly see, loyal shareholders with a long-term horizon were richly rewarded with the run up of the stock price until 2016.

Unfortunately for Sepura, a badly conceived and debt-fuelled acquisition made in May 2015 along with weakness in its core business generated crippling losses which the fragile balance sheet just could not sustain. Despite raising money through a rights issue in June 2016, profits collapsed further and the company was forced to put itself up for sale, only months later. With the liquidity position of the company in a critical position and a lack of incoming bids, the Board had to accept an offer of just 20p a share from a Chinese competitor called Hytera.

Merger Arbitrage

After watching the entire spectacle from the sidelines, it was at this point I stepped in thinking I could play the role of arbitrageur in order to pick up the spread between the current share price of about 19p and the offer price of 20p. The Scheme Document outlining the takeover proposal gave a timeline which suggested that anyone buying at 19p in January, would have to wait no more than 2 months to pocket the 20p offered when the deal was expected to close in March. Of course, there is no such thing as a free lunch – takeovers can and do break down, so it’s up to investors to do their due diligence in determining the likelihood of the takeover failing. This is where my hubris kicked in.

Before the takeover could be approved, it needed to be approved by shareholders, Spanish and German regulators. I deemed that Spanish and German regulatory approval should just be rubber stamping of the deal. If the British themselves can allow one of their own companies be taken over, there should be no such issue with German or Spanish regulators blocking the move. I thought that the possible spanner in the works would come from shareholders blocking the takeover. I knew from the takeover documentation that the Chinese company possessed a letter of undertaking from 38% of shareholders guaranteeing their votes in favour of the takeover. Having done some further due diligence telephoning up connections with other large shareholdings, I was confident that the other large institutional/individual shareholders would also approve the deal, thus giving the required 75% required to push the deal through. With another merger arbitrageur operation (Cigogne) having moved in with a 5% position, it looked like the stars had aligned and the shareholder vote would be a formality. Indeed, come the EGM the deal was approved by shareholders unanimously – it was time to pop the champagne corks.

Doubt

Just four days later, Sepura then issued an RNS casting doubt that regulatory approval would be granted for the takeover. The share price plunged and I scrambled madly to try and learn about German competition and takeover rules. What I learned was not comforting. It seems that after a number of German companies had been acquired by the Chinese in 2014 and 2015, and now the German government was very concerned that further key European technologies relating to telecoms, robotics, and security were falling into Chinese hands. Indeed, it appears that the German government can (and have) blocked any such takeovers of such companies on national security grounds. With the takeover now under further investigation from the Germany competition authority for at least the next 3 months, I sold out my position and took my loss. With Sepura already in breach of banking covenants and the very real possibility of them taking control of the company and handing shareholders a zero, I just could not take the risk. Perhaps the deal will go through in three months time, perhaps not. If you wish to get involved and follow, you can track it here. For me though, I am out. A possible 100% loss for a 30% gain is just not a game I want to play.

Lessons Learned

  • One of the justifications I used for this investment was that other large investment banks and hedge funds had been increasing positions in the company in the run up to the shareholder vote, presumably with the same intent as mine, hoping to arbitrage the deal. It was silly to automatically assume that they must know what they were doing.
  • Thinking I knew all the answers when I quite clearly didn’t. What’s worse is that I had actually previously read about takeovers falling afoul of the German government – yet it was still a complete blind spot here.
  • Getting involved with a debt zombie that had no future should the takeover fail. With net debt at £80M and free cash flow in £10M in a very good year, it was clear that Sepura has a high degree of failure without a takeover.