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.

M Winkworth – New Holding

M Winkworth – LON:WINK
Share Price – 95.3p
Market cap – £12.35mn

First of all, let me just say that this not an original idea. Maynard Paton has wrote extensively on this estate agent franchiser for quite some time and it was he who first brought the company to my attention. I was attracted by the excellent business economics that the business has, and also the fact that it’s trading at a 52 week low. With a PE now well into single digit figures, I did more investigation of my own, and decided to take a position.

I am linking to all the posts that Maynard has written about M Winkworth. Indeed, rather than regurgitating an introduction, I am just going to skip it. The below blog posts provide more than enough background on this company. Please refer to them before proceeding any further.

Cutting To The Chase

If you had looked at the above numbers for the previous 5 years worth of financial data, you would say that this was a good quality, growing business that is deserving of a premium multiple. Unfortunately, the cyclical nature of the property business means this is something we’re never likely to see. Having said that, has the nature of this cyclicality been over-egged into the current share price?

Clearly, Winkworth is a business with highly attractive economics. It requires almost no capital to run, it has excellent margins, it scales, and it generates high amounts of free cash flow and it is managed by a young, owner operator. Of course, for a company of this quality to be trading at a PE multiple of just 8, there is clearly a perception of expected problems down the line. I believe these are the two most pertinent issues that face M Winkworth.

  1. A crash in the London property market.
  2. Structural impairment of the business thanks to online competition.

Regarding the first point, a crash in London property is something I have reconciled myself to. A collapse in revenue and profits is not an ideal outcome in any investment, but I think the real question to ask is whether such a crash would structurally impair the business? As Maynard pointed out, such a eventuality did occur during the great financial crash in 2008. Rather promisingly, while revenues and profits were impacted severely, the business itself remained profitable during the worst two years (just about) before recovering quite nicely in subsequent years. As a long-term investor, that strongly suggests that I can ride out any potential property crash in London.

The second point is of more concern. As we’ve seen in the last few decades, the internet disrupted many traditional businesses (news, advertising, retail) and now threatens a number of other industries. Are traditional estate agents the next to be disrupted? The rise of fixed-fee providers like Purple Bricks have set out to try and eat the lunch of the established players like Winkworth and Foxtons. I certainly would not be popping the champagne corks yet, but judging how Winkworth have been able to maintain their margins and grow their top line, I am not convinced this is the end of bricks and mortar estate agencies. With that said, it’s certainly a situation that I will have to monitor closely.

Synopsis

Winkworth is a growing business with attractive economics that is trading at a price that indicates it has a poor long-term future. While I cannot predict the future of the property prices, I do feel that a margin of safety is provided by the solid balance sheet, the positive cash generation of the business, the owner operator orientation and the diversification of the business into other lines (lettings, corporate relocation, etc).

Portfolio Update – 2016 Year-End

Introduction

With the year now over, I thought I would do a quick re-cap of my performance in 2016 and how my portfolio is now positioned going into the new year. Firstly, let me give you the end-year return.

2016 year-end performance: 39.52%

The year 2016 was a roller-coaster to say the least. In Q2, Brexit saw my portfolio sustaining an eye-watering one day decline as financials across the board were dumped by nervous investors. Q3 provided some relief, before the sector took off like a rocket in the aftermath of the election of Donald Trump and fall in long-term treasury yields. Throughout the tumultuous period, I stuck to my conviction that financials were under-priced and bought more Barclays after prices collapsed in the aftermath of Brexit. Wanting to get more diversification in the portfolio, I then opportunistically took advantage of weakness in the share price of both Vienna Insurance Group and Wells Fargo (not covered on here, but covered extensively elsewhere).

Current Portfolio Weighting

  • Barclays PLC: 74.5%
  • Vienna Insurance Group: 11.9%
  • Wells Fargo: 13.6%

2016 Position Performance

  • Barclays PLC: 45.52%
  • Vienna Insurance Group: 26.56%
  • Wells Fargo: 22.76%

Activity

During 2016, I made 4 separate purchases of shares, the first two were for Barclays (pre and post-Brexit decision) and the other two were for positions in Vienna Insurance Group and Wells Fargo. No positions were sold at any point during the 2016 period.

Going Forward

Barclays: For my small portfolio this is an over-sized position. Having said that, when I compare it to competitors in the sector, it’s still cheap. It trades at about 75% of tangible book value, owns some very valuable businesses that are offset by other money losing, non-core operations that are being sold, and has what I regard as good management who are trying to take the correct long-term decisions for the business. I think that given the progress made that it’s worth at very least tangible book value, implying a 20-25% gain from the current price.

Vienna Insurance Group: My original conviction in buying this company was that it was a decent business that had operational/macro difficulties, but traded at considerably below fair value. Since then a new CEO has been appointed, we’ve seen some kitchen sinking of the bad news, and subsequent write-downs on both earnings and the balance sheet. Thankfully, things have settled with forward guidance suggesting that this is currently available at less than 10x earnings. With that said, having my portfolio engaged in an insurance company that has operations in Bucharest and Belgrade doesn’t comfort me. If I get anything close to fair value, I am more than happy to take advantage of liquidity on the way out of this one.

Wells Fargo: If there was ever proof that sometimes good things come to people who wait, it was Wells Fargo in Q3 of 2016. Seeing this company trade at as little as 11x earnings when the overall PE for the S&P was over twice that number was something that beat me over the head and until I sat up and bought some shares. The Trump rally has resulted in a re-rating of these shares. However, in comparison to the market, Wells Fargo still trades at a considerable discount, so for now I am content to hold these in my portfolio.

Conclusion

2016 offered me one fantastic company where to put money to work and two other decent opportunities to invest in. As of the start of 2017, I do not see the same opportunities present themselves. While I don’t like playing the macro game, or market timing, I do feel that certain equity markets are overpriced (US for example). I have no pre-cognition towards the future direction of equities, but I will always want to fish in a market where value is more readily available. With that said, the UK and Europe is the place where I would be expecting to make further purchases going into 2017.

Civitas Social Housing – December 2016

Civitas Social Housing – LON:CSH
Share Price – £1.04
Market cap – £364M

Analysis

Civitas Social Housing came to market in an IPO just a few days ago and attracted my attention. For those of you who are curious, the prospectus is available to review here, it proclaims the following.

The Company will be the first REIT to be listed on the London Stock Exchange which offers a pure play exposure to Social Housing.

The first “pure play” social housing REIT?  Sounds wonderful, because surely a REIT that wasn’t a “pure play” on social housing would be a terrible thing? Regardless of my cynicism, management will undoubtedly be pleased that the offering was over-subscribed, raising the maximum possible amount of £350M. Excluding the £5M of listing costs, that leaves the company with a NAV of £345M, meaning on a current share price of 104p, the company trades at a 5.5% premium.

After reading about the 5.5% premium on the share price to NAV, I pretty much stopped my analysis immediately. Since other larger UK REIT’s are often trading at a discount to NAV, offer ~5% dividend pay-out’s, and are already established – why would anyone take a risk on buying into this shaky business model of being dependent on government subsidies with insiders having almost no skin in the game?

Disclosure

No position

Lakehouse PLC – December 2016

Lakehouse – LON:LAKE
Share Price – £0.28
Market cap – £44.1m

Introduction

Lakehouse caught investors attention in early 2016 after it spectacularly imploded just months after going public in a well-publicised IPO that attracted many respected investors. Since seeing 60% of the value being wiped off the company in just one day, the bleeding has continued since then with several profit warnings being declared and the entire management team eventually being replaced. After such a fall, and a change of management, it’s natural to reappraise the company.

Let’s start from the beginning and talk about what Lakehouse does.

Lakehouse is a leading asset and energy support services group, focused on customers in the UK outsourced public and regulated services sectors. The Group delivers a range of essential services through a successful model based on long term contractual relationships with local authorities, housing associations and energy companies.

The above is taken from the Lakehouse website. Rather helpfully, the company breaks down the specific types of work that they’re engaged in, and how much accrues to the top line. Below are the most recent 6 month numbers with a description of the divisions activities.

breakdown

You can see there is a good mix of work, both public and private, across different sectors, but with a fairly heavy concentration in property. Out of the four areas that the company operates in, two of them are in trouble, Energy Services and Regeneration. The most recent trading update had this to say.

As reported in the Interim Results, the Board remains focused on resolving performance issues in the Regeneration division.  This includes a number of contract settlements on which there is a range of potential outcomes for the Group, both in terms of cash flow and impact on the Income Statement.  Management anticipate there are likely to be further write-downs, during the current financial year as we seek to close out these issues with clients.  Based on current discussions, this is expected to have an adverse impact of £4 million in the current financial year.  

The Board notes the ongoing consultation concerning the UK Government’s policy on Energy Company Obligations, which is due to enter its third phase on 1 April 2017. The outcome of this consultation is crucial to determining the levels of funding and, as importantly, the types of works that will be funded.  We remain in active dialogue with Government over the future direction of policy on energy efficiency, which we see as critical to achieving the legal obligations the UK has to deliver carbon savings and will influence the Board’s overall outlook for the Energy Division.

Performance issues in the Regeneration business is certainly understating the issue, especially given how that division has imploded so badly in the last year. The contracts settlements issue that will result in a £4M write-off is actually up from just £2M reported in an earlier trading statement from the year. Is this now capped? I don’t know, but I have noticed that the old MD of the Regeneration division has left the company. With a new person now running that part of the business, perhaps a line has been drawn under those problems and the division can return to positive EBITDA? Historically, the Regeneration business was by far the biggest part of Lakehouse before it went public. Perhaps with renewed management focus, things can be turned around?

The second part of the trading update sounds like there’s likely trouble to come in the Energy Services division. This actually worries me more than the woes that the Regeneration business faces. There is always going to be a need to have kitchens installed or roofs repaired. If Lakehouse slips operationally (as they have), this damage can be possibly be repaired. Energy Services on the other hand is something that’s much more out of the hands of management. If the government subsidies for the installation of smart meters and house insulation cease, then this revenue is not coming back. With the government now firmly focused on Brexit and preventing any economic fall-out, I suspect that green initiatives are the last thing on their minds. I am expecting more bad news to come on this front.

Financials

Going onto the financials, it’s worth saying that the support services industry that Lakehouse operate in has always been a low margin business. Lakehouse certainly doesn’t disappoint on this score with margins that are even worse than others in their industry. Below, I’ve presented a comparison of Lakehouse with peers in the support services sector. Clearly by industry standards, Lakehouse have very poor margins. I suspect the root cause here is the 6 acquisitions that the company did in 12 months. When you consider that the company already operated in a handful of other businesses, it’s not at all surprising that the ball was dropped and operationally things slipped quite badly. With better management, surely things at Lakehouse could be turned around?

capture

Shareholder Revolt

After the share price collapsed by 70% from IPO, and with the operational difficulties mounting and company liquidity tightening; it certainly wasn’t surprising that management were replaced by disgruntled shareholders. This was all well-publicised  and is thankfully water under the bridge. What is worth noting however is just who the company brought in to try and turn things around. Bob Holt, founder of the Mears Group, is clearly a proven operator who has been brought in to straighten the company out. If my suspicion holds true that Lakehouse can be tightened up operationally, then Holt is undoubtedly the man for the job. Unfortunately, Holt’s expertise comes at a cost, and it’s certainly worth reviewing his pay package.

  • 2% of the company granted at no cost just to take the Chairman position.
  • £75k salary.
  • Up to £150k in consultancy fees.
  • A bonus applies if the share price goes above 58.57p (£400k at least), above 78.48p and again above 98.4p (up to £1.3M).

The important thing is that other than the 2% golden hello that Holt received, additional compensation that would be considered egregious doesn’t kick in until at least the share price goes up by at least 60% from the current levels. The incentives are clearly performance led and I suspect are structured in way that Holt feels are achievable.

The only thing I am concerned about with Holt’s appointment is the potential for a conflict of interest given that Holt will be retain his role at Mears Group. The recent General Meeting acknowledged this, and had this to say about the matter. Personally, I didn’t find it very convincing.

Although the Board recognises that there may be occasions where such conflicts arise, your Board believes that the number and extent of any such conflicts is likely to be minimal as a consequence of there being limited overlap between the nature of the operations of Mears and the other companies’ operations and the operations of the Company.

Conclusion

Lakehouse clearly has problems. Low margins, operational weakness, a poor capital position, board turmoil, a difficult trading environment – these are all factors that make Lakehouse look an absolute mess from the outside. Having said that, there is possibly opportunity here. By and large, the majority of the business that Lakehouse do is real, stable with visibility into the order book. There are certainly risks with government spending cuts; but this is something that competitors have seemingly been able to handle, so why not Lakehouse too? If the company can hit just a 3% operating margin in-line with the average figure that Mears and Mitie Group do, we’re looking at income of £10M. If we put a 12x multiple on that – the share price is a 3-bagger from here. On a 2% operating margin, and with the same 12x multiple, the share price should double. The potential upside on hitting reasonable targets is clearly compelling.

For now though, I haven’t quite made up my mind whether I should buy ahead of the trouble in the Energy Services division, or should I wait for the bad news, hoping for further falls.

Northern Bear

The eagle-eyed folks here will undoubtedly be reading this though and telling me I have missed the point here completely. This post was initially just to learn more about Lakehouse and evaluate it as a potential investment. Instead, it only served to throw up another prospect. If you re-examine the comparison I did with other companies in the sector, the one that really stands out in the analysis is Northern Bear. While still tiny, this has been a fantastic business with decent growth that is trading at a very low price to free cash flow multiple. I have not had a chance to cover this in enough detail, but on initial investigation, it looks like an under-followed gem.