re: Ann: Full Year Results Announcement and I...
Corporate,
I am well, thanks for asking.
Reason for not posting recently is that I have been out of the country for some months.
By coincidence, I was just updating my COF Scenario Analysis spreadsheet for today’s result.
I also took some time out today to listen to the presentation by Managing Director, John Douglas, and Finance Director, Urs Meyerhans.
Pleasingly, this result has fully reinforced the investment thesis that I have for this company.
I think what few people appreciate is just how much of a pickle this company found itself in over the past two years, veritably finding itself in the perfect storm courtesy of:
• An excessive acquisition strategy undertaken by previous management, • An overextended balance sheet right at the point when revenues started to evaporate courtesy of the stalling resources sector, • High staff turnover (the very assets that were acquired during the boom time were walking out the door [literally!] and • A fixed cost based geared for a revenue base that did not eventuate.
Against this forlorn backdrop, the new board and management (only one of the seven directors – including the Managing Director and the Finance Director - has been with the business prior to 2010) have done an impeccable job, I believe, of stabilising the business, and getting the balance sheet into a less dangerous shape.
And remember that this was all done in an acutely challenging business environment over the past 18 months.
Despite the fact that earnings have been under severe pressure, the focus on surplus capital generation has resulted in some very significant trends in financial performance that the P&L has masked.
Specifically:
Net Debt has fallen: June 2010: $112m June 2011: $127m June 2012: $70m (a $39m equity raising assisted in this year) June 2013: $65m (despite $6m of restructuring cash payments made in the year)
The interest bill has fallen commensurately: FY2010:$12.2m FY2011: $15.4m FY2012: $14.8m FY2013: $10.0m
Free Cash Flow (defined as Operating Cash Flow LESS Capex) has turned around impressively: FY2010:$12.5m FY2011: -$17.4m (yes, negative FCF) FY2012: $14.5m FY2013: $11.0m (adding back the $6.4m cash outflow related to restructuring, this would have been $17.5m)
What I find striking is that this company, despite going through the mother of all downturns in its business during the past two years, and with its balance sheet labouring under severed indebtedness, still managed to generate significant FCF.
That, I think is a significant statement for investors to consider.
And the reason this is worthy of focus and attention is due to the fact that the interest expense in this company is very material relative to its reported profits.
Specifically, Net Interest Expense has, over the past four years averaged a whopping 150% of Pre-Tax Profits (in FY13 it was 100%).
The investment implications of this should not be lost on discerning investors: clearly, if the Interest Expense line can be reduced – or be made to disappear entirely over time – then the impact on bottom-line profitability will be dramatic, to say the least.
Which is why I run several scenarios that simulate the effects of this.
My assessment for each scenario, and the resulting share price return potential on offer, is as follows:
SCENARIO 1: NO REBOUND IN CURRENT CYCLICALLY LOW EBITDA FROM FY13’S $28.8M (despite the Slide 13 in today’s presentation alluding to $10m in fixed cost reductions and $22m in reduction in reduction in chargeable costs expected in FY14)
Net Interest Expense I model as falling to around $7.5m in FY14 [due to lower debt levels, lower cost of debt, and in the second half of FY14 there will be a circa $1.0m reduction in Net Interest Expense due to maturing interest rate swaps], and to around $6m in FY15 [again, lower absolute debt levels and lower cost of debt as well as a further $1.2m non-recurrence in interest rate swaps].
From just this deleveraging of the P&L – i.e., excluding any improvement in operating performance – simple arithmetic shows that Pre-Tax Profits would rise by 20% pa over the next two years!
If the stock simply held its current EV/EBITDA multiple of 3.5x, it would provide a 20% per annum share price performance.
Even under such a stodgy earnings outlook, the solvency metrics would improve greatly, as follows:
NIBD/EBITDA would fall to 1.6x at the end of FY2014 and 1.3x by FY2015, compared to 2.0x currently. EBITDA/Net Interest would rise to 3.8x in FY2013 and 4.9x in FY15, compared to 2.9x registered in FY2013.
Such is the cash-generating ability of the business.
SCENARIO 2: MODEST REBOUND IN EBITDA FROM FY13’S $28.8M...NO VALUATION RE-RATING ASSUMED
Assume 3% EBITDA growth in FY14 and FY15
This would result in 27% per annum growth in Pre-Tax Profits.
And therefore a 25%-30% per annum share price performance.
SCENARIO 3: MODEST REBOUND IN EBITDA FROM FY13’S $28.8M...MODEST RE-RATING ASSUMED
Here I assumed: - 3% EBITDA growth in FY14 and FY15 - Modest re-rating of 0.5x per year in the EBITDA multiple, i.e., 4.0x by the end of FY14 and 4.5x by the end of FY15
Like SCENARIO 2, this would result in 27% per annum growth in Pre-Tax Profits.
And the re-rating would result in a 60% share price rise in FY14 and a further 40% share price rise in FY15.
Accordingly, the two-year share price target would be 40c under this scenario.
I assumed: - 5% EBITDA growth in FY14 and 15% growth in FY15 - Re-rating of 1.0x per year in the EBITDA multiple, i.e., 5.0x by the end of FY14 and 5.5x by the end of FY15
This would result in 44% per annum growth in Pre-Tax Profits.
And the re-rating would result in a 130% share price rise over the course of FY14 and a further 50% share price rise in FY15.
Accordingly, the two-year share price target would be over 60c under this scenario.
Under this more bullish earnings outlook, the solvency metrics would improve greatly, as follows:
NIBD/EBITDA would fall to 1.5x at the end of FY2014 and 0.9x by FY2015, compared to 2.0x currently. EBITDA/Net Interest would rise to 4.0x in FY2013 and 5.9x in FY15, compared to 2.9x registered in FY2013.
I don’t have a firm view on which Scenario will ultimately play out; I will re-calibrate my model settings along the way over the next two years.
But one thing that today’s result has confirmed to me is that the business is being stabilised, and that earnings (both operating and especially bottom-line) have bottomed and, given the “doomsday scenario” valuation multiples on which the stock currently trades, I believe firmly there is little further downside to the stock.
I have been acquiring the shares over the past few months after the profit downgrades in May, and bought more again today immediately on reading the result, and again after coming off the webcast presentation by management.
In an equities world where obvious undervaluation is hard to come by, COF stands out to me as offering highly attractive upside potential versus reduced downside risk, following today’s result.
Good luck
Cam
PS. The inflexion point at which I believe COF is today reminds me a lot like that of another small cap business I have followed for some time: SDI.
SDI was, some 12 to 18 months ago and like COF is today, facing several major external business challenges that caused the market to overlook the excellent job that management was doing internally.
Once the market focused on the BUSINESS itself, and not just the "MACRO" noise, the stock underwent a significant re-rating in the market.
I am not suggesting that COF can increase in value by six- or seven- or eight-fold like SDI has over the past 12 months, but I do believe similar foundations are in place for the stock to appreciate significantly.
COF Price at posting:
17.5¢ Sentiment: Buy Disclosure: Held
(20min delay)