To: Ocker, cc: Dejavoo et al,I'm not sure whether we all...

To: Ocker,
cc: Dejavoo et al,

I'm not sure whether we all (management included) are consistent when quoting EPS growth outcomes versus expectations.

Here's my interpretation of things:
Management guidance was for EPS growth of 25% on last year's reported figure of 30.2cps. Reported EPS for FY10 was 36.2cps, implying 19.9% EPS growth, "shy" of management "guidance", so it is indeed "a miss" (whatever that means in the context of the life of a business and the investment time horizon of deep value investors).

Now I suspect some fans of the stock might point to the fact that this result contained $0.7m in restructuring charges, so normalising for this yields FY11 EPS of 37.2cps, implying 23.2% EPS growth. However, this is to compare apples with oranges since the FY09 result contained $2.5m of restructuring charges, which are included in the 30.2cps reported EPS number. Normalising FY09 EPS for this item yields EPS of 34.0cps, so that the UNDERLYING growth at the EPS level in the business was 37.2 divided by 34.0, which equals 9.4%. I think that this is the figure that should command our stare as investors, and I think other measures are misrepresentative.

So, on my calculations we have a business that grew on an underlying basis at some 9%. For context, recent history of EPS growth is as follows (all figures sanitised for non-recurring items):
FY05: -18%
FY06: -31%
FY07: +20%
FY08: +41%
FY09: -17%
FY10: +9%

In order to further dimension MCP for valuation purposes, note that revenues are today some 12% higher than their level in 2004, which translates into a 1.8%pa compound annual growth rate (nominal terms), which is below system growth.

So definitionally, MCP is not a growth stock. It is, however a highly cash generative business (long-term, OCF-to-Sales averages almost 5.5 times, and in the past 3 years it has averaged 8.0x, and on average 48% of EBITDA drops through to Free Cash Flow). This is relevant for the multiple one should apply to the stock.

Looking at MCP's valuation metrics:
I expect a flattish operating performance in FY11 with EBITDA of $51m (FY10 = $50.6m). NPAT will show some modest improvement, to $27.5m (FY10 = $26.4m, normalised), principally due to a lower interest expense on reduced levels of carried borrowings.

Assuming Working Capital-to-Sales moderates to 23% (at June '10 balance date this ratio jumped to 24.5%, a record high for the group...more on this later), capex of around $3.0m pa, and maintained DPS of 20c for FY11, this results in Net Interest Bearing Debt of $54m @ 30 June 2011 (down from $72m @ 30 June 2010).

Added to the $205m of market cap results in a projected June 2011 EV of $260m.
Resulting valuation metrics are:
EV/EBITDA = 5.2x,
P/E = 7.6x,
DY = 7.1%,
FCF yield = 16% on Market Cap and
FCF yield = 13% on EV.

Before the GFC these would be the sorts of valuation multiples that investors would leap at wholeheartedly. However, because capital markets have become definitively more accident prone, investors need to accept a structural de-rating of equities will be a feature of the investment landscape for many years to come. (I remain amazed at the level of denial on the part of equity market strategists who argue that the market is currently trading on a P/E of 12x, compared to its historical average of 15x, which means equities are undervalued and that the equity market must therefore go up. That they fail to acknowledge that the Equity Risk Premium has undergone a structural increase as a consequence of the GFC fallout, is astonishing. Verily, twelve times is the new fifteen times!)

Back to MCP?s valuation: I consider my approach to investing to be far more conservative than most. So for a small cap stock growing DPS at 10%pa, with a durable, scalable and cash generative business model as well as a competent, honest and aligned management team, I look to acquire on valuation multiples that satisfy as many of the following levels as possible:
<11 times P/E,
<5.5 EV/EBITDA,
>10% Free Cash Flow Yield (on EV), and
>6% DY (sustainable).

However, for a business like MCP, which is more of a fixed income proxy given its lack of growth attributes, I think 7.5x to 8.0x P/E or sub-5x EV/EBITDA is what I would consider to be appropriately undervalued to induce buying. So MCP doesn?t quite make it for me on those measures. Almost, but not quite.

However, on the criteria of FCF yield and DY, the stock is within my buying range, especially when the QUALITY of the Free Cash Flow is analysed: I believe firmly that not all EPS or all EBITDA are made equal (something the vast majority of investors fail to recognise, I feel). MCP has quite a ?unique? kind of EBITDA in that a lot of it (more than half) translates into Free Cash Flow and importantly, this occurs with a degree of reliability that I am able to identify in few companies (EBITDA/FCF is one of the key diagnostics I apply when considering buying a business, private or public).
For MCP past EBITDA/FCF has been both high and remarkable stable:
FY04 = 63%
FY05 = 39%
FY06 = 49%
FY07 = 54%
FY08 = 50%
FY09 = 38%
FY10 = 51%

Usually, my investment philosophy is to buy a rising dividend stream at a steep enough discount to its intrinsic net present value. While MCP does not present scope of dividend growth, its static dividend stream is cheap enough for me to buy it now.