Ann: March 2021 Quarterly Trading Report, page-7

"What are you getting at here ???"

@ppa1969,

I guess I'm trying to draw some attention to one of the idiosyncrasies of deeply cyclical businesses such as this one, namely that the way the market values them can often be quite counter-intuitive.

What I mean by that is that their valuation multiples tend to be highly variable, depending on the point in their business cycle.

Take XRF: its P/E multiple has varied from single-digits to as much as 30 times.

Moreover - and this is the counter-intuitive part (and the most important part, too) - the P/E multiple is its highest when the earnings are at their lowest, e.g.,between FY2016 to FY2018 (denoted by Area B in the chart below), while the P/E multiple gets compressed as earnings approach cyclical peaks (denoted by the period during the past commodity boom - Area A: FY2011 to FY2013).




Given we are clearly into the upswing of the current cycle, the important questions that require answering are:

1. How high can EPS get this time?
2. At usual peak-cycle P/E multiples of around 10 to 11 times, what share price results?

In terms of Q1, it would be unfair to say that EPS at the current peak would reach around 2.8cps because that's where it got to at the last cyclical peak in FY2013. The reason this simple assumption is flawed is because the company's asset and equity base is meaningfully larger today than it was in 2013.... In FY2013 Shareholder Equity was 29m; today it is around $38m.

So a more appropriate way is to run the exercise off like-for-like ROCE or ROE metrics.

In FY2013, the company made $3.7m in NPAT based on $28m of average Shareholder Equity over that year, so ROE at the earnings peak was 13.2%. [*]

If we assume - somewhat generously - that the Shareholder Equity will increase by a further 10% over the next 12 months to reach around $39m to $40m iat the end of FY2022, then a 13.2% ROE on that figure results in implied NPAT of $5.2m, or EPS of 3.8c (so a good 35% to 40% higher than the previous cyclical high of, recall, 2.8cps). This

Applying the previous peak cycle P/E of 10 to 11 times to 3.8cps peak cycle EPS (corresponding the Area C in the chart) yields a peak share price of 38c to 40c.

So I concede that maybe "G= Greed?" in my preceding post was a bit of an embellishment; maybe it should have been "F= Fair Value" (But then there would be two "F's in the chart, namely F = Fear and F = Fair Value), and I'm not sure that would have made much sense.

But the point being made was that I believe the stock has now reached what I consider to be fair value.

Another way to view relative value is that 9 months ago, the stock was trading at a near 50% discount to its book value, which is too low for a business that generates RoCE close to its cost of capital (In theory, Price-to-Book should be 100% when RoCE equals Cost of Capital).

Today P/B is almost 150%, which is too high for a business that barely earns its cost of capital.


[*] That this business makes a mere ~13% ROE at the peak of its business cycle (through the cycle ROE is around 8%, so barely covering cost of capital) informs the somewhat mediocre quality quality of the business, and why the market is unlikely to apply/pay anything but modest valuation multiples to the stock.

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