bly seeing in the context of shareholder value

[This post is in response to some debate with HotCopper member "mbeard" on another forum.]

(And I at the outset would like to apologise in case I offend any BLY shareholders for expressing my views here. I don’t mean to provoke or appear “I-told-you-so”-ish.
I’m just calling it like I see it according to my own investment philosophy, so I respectfully request please not to open fire on the mere messenger)

Mr Beard,

You were musing aloud whether BLY’s 40% share price fall following the result was warranted.

Unfortunately I think you’ve definitely asked the wrong person, but I’ll bore you with my opinion, since you asked.

My answer is prefaced by sharing my belief that there are three broad types of investors who invest in shares.

At the risk of stating the obvious, all three of these types of investors do so with the expectation that the share price goes up in time.

But where each type of investor differs markedly is their respective beliefs in different mechanisms and/or determinants of share price movements:

TYPE 1: Those that believe they can predict share price movements without really understanding the business behind the share price (technical chartists, people who look at the “depth on the buy and the sell sides”, and people who believe they can effectively ride the waves of thematic, sentiment and/or macro situations all fall into this category)

TYPE 2: Those who believe they understand the fundamentals of the business because they look at point valuation multiples (such as P/E multiples or EV/EBITDA) which they believe provide pointers to subsequent share price performance, and

TYPE 3: Those who buy shares in businesses that are demonstrably capable of creating shareholder value, in the belief that, as the company’s intrinsic value grows, so too the share price will follow.


It should be apparent that Type 1 and Type 2 are different in approach, from Type 1, in that:

- For Types 1 and 2, the focus is very much on the share price itself (where it has been, what it did today, this week, this month, this year etc., whether or not insiders are buying or selling, what the high frequency algorithms are doing to the share price, how many buyers are “lining up”, compared to the sellers [THE most futile exercise I’ve come across], whether the Big Boys (whoever they are) are buying or selling etc., whereas

- For Type 3 the focus is almost exclusively on the business and its “Financial Pedigree”


Over many years of interaction and observations, I have concluded that Types 1 and 2 represent about 99% of market participants.

Type 3 represents a tiny minority, of which I strive to be one.

I can therefore offer you nothing at all in terms of insights as a Type 1 or Type 2 investor, which is what I think you were probably after, but speaking as a Type 3 investor, the thing I turn to is hard, cold valuation based on the definition of the company’s Financial Pedigree.

Four broad factors define the “Financial Pedigree”:

1. DEBT FILTER
2. ROBUST BUSINESS MODEL
3. ACCOUNTING QUALITY
4. MANAGEMENT COMPETENCE, INTEGRITY & ALIGNEMENT

In the interests of brevity, I have, as an Addendum, at the end of this post expanded in greater detail what I believe these factors to mean in the context of valuing a company (or more, specifically, determining whether or not it is worth buying, i.e., whether it can be considered to be “investment grade”.)

Unfortunately, as you already seemed to have concluded, I am not a fan of BLY.

Worse, in fact: I do not consider the stock to be investment grade.

And this means that there is not realistic price that I would pay for it. (I’ve heard the catchcry of: “Everything has a price”, but my investment philosophy does not subscribe to that theory).


Here’s why it isn't investment grade, in my opinion:

Assuming you were a shareholder in BLY for, say, the past 5 or 6 years which, by the way, was a period that coincided with the one of the most glorious and almost unprecedented mining booms.

Intuitively, you might expect to have become financially enriched by your investment in a mining services company such as BLY.

Instead, here’s what actually happened.

Your company started out generating about $100m in EBITDA in 2006.

And analysts tell me that next year (FY13) it will generate $300m in EBITDA (and we need to look at next year because the equity market, by its anticipatory nature, is forward-looking)

You might say, “Well, a trebling in EBITDA. That’s still not too bad.” [And that, of course, assumes analysts are right about their FY13 EBITDA expectations, in the first place, which I very much doubt. But, while we have no reason to, let’s give them the benefit of the doubt.]

But now let’s analyse what happened in the company’s capital account to achieve that “growth”.

Between 2006 and the present:
- BLY generated a cumulative total of $674m in Operating Cash Flows
- But the company consumed almost $1.3bn in the form of capital expenditure and acquisitions.
- To make up the difference, shareholders have had to contribute to the company coffers in three years out of the past six in the form of equity raisings.

These raisings have totalled a whopping $2.9bn [although, to be fair about $500m, in 2006, I recall vaguely, was to settle the purchase the a business as part of the IPO, and about $1.2m was required to redeem some debt instruments in 2007. But even if you exclude these, the company has an inability to fund its growth organically.]

BLY has raised almost $3bn from shareholders, and given back just over $100m in dividends.

The business simply fails to generate surplus capital; it’s a capital sponge.

Take for example, the past 3 years since the company raised $650m-odd in 2009, to pay down debt.

Immediately after that raising, Net Interest Bearing Debt was just $48m, reflecting NIBD-to-EBITDA of just 0.4x.
Today NIBD is almost $400m and EBITDA-to-EBITDA has risen to 1,3x

And that fiscal deterioration has taken place during a period of unsurpassed buoyancy in business conditions for companies BLY.

So there is clearly a disconnect between the company’s accounting profits and its cash flows, and whenever I see that sort of disconnect, it sets off warning bells for me.

I have a term for this sort of disconnect: “Profitless Prosperity”, where the company certainly appears to be “earning” more, but none of the earnings improvement is trickling down to the owners of the business.

Now, the natural rebuttal to this sort of “negative” analysis is, “Yes, Cam, but the company is growing; of course it needs to invest capital to grow.”

Sure, that’s true, but there are many companies that do so, not just without recourse to shareholders, but with the ability to accelerate returns to shareholders at the same time.

The ultimate arbiter of shareholder value creation is the ability to sustainably increase returns to shareholders.
BLY cannot.
The nature of the business simply doesn’t permit it.

For fuller clarity, let’s qualify the magnitude and the quality of the growth:

Look at the past 4 years: from in FY07 to FY11 (both which were boom years, so we are comparing apples with apples, I argue):

Total Capex and Acquisitions over that period came to $700m.

The corresponding financial performance was as follows:
- FY2007: Revenue was $1.58bn, EBITDA was $297m, EPS was 44cps
- FY2011: Revenue was :$2.02bn, EBITDA was $356m, EPS was 35cps

Conclusions:
1. $700m of capital was deployed for a ~$60m EBITDA accretion. i.e,, an implied investment multiple of almost 12x EBITDA (somewhat woeful for a stock routinely trading at 4 or 5 times EBITDA.)
2. $700m of capital has been deployed for 20% diminution in Earnings Per Share, from 44cps to 35cps. (Put another way: $1.50 per share has been spent in order to reduce value by 70cps [taking the 9cps reduction in EPS and capitalising it on a multiple of, say, 8 times)

Enough said, I think.


Then there’s the matter of the remuneration of the company executives, which I think are obscenely generous (Refer the Remuneration Report in the 2011 Annual Report, pages 29-53).

The CEO makes over $4m pa and the 6 non-executive directors together cost the company around $1.0mpa.
The chairman earns $300,000pa. The company holds just 6 board meetings per year.

Short-Term Incentives kick in at an operating margin of just 5% (30% of the STI accrues at this point), increasing to 90% accrual at an operating margin of 15%, and 150% for an operating margin of 20%.

And then on top of that, there’s a Revenue Growth multiplier that starts to apply from zero revenue growth, i.e., if revenues remain unchanged, the Revenue Multiplier, which applies to the accrued STI’s, is 1.0. 10% Revenue growth attracts a multiplier of 1.07x, 20% revenue growth corresponds to multiplier of 1.13x, 30% to 1.2x, 40% to 1.27x

I note that, over the past four years, an average STI of 92% has been enjoyed by BYL executives, despite some volatile financial results over that period including a net loss in FY09, when the STI payout was 99%, strangely enough.

Long Term incentives kick in at a ROE of 6% (an offensively laughable hurdle...you can do better leaving your money in the bank), between ROE of 9% and 11% full bonus is awarded, between 11% and 13%, 125% of the incentive accrues, and above 13%, 150% of the STI accrues.


So, to answer your question as to whether BLY’s 40% share price fall is justified, I’m inclined to answer – cynically – that what probably wasn’t justified was its share price before the drop.

I suspect I wasn’t much help here, but when I conclude that a business can’t – and won’t – create value for its shareholders, I can’t value it.

And so I won't buy it.

No matter what its price is.


I apologise if this sits a bit uneasy with you, and I stress that I don’t believe I have a monopoly on getting everything right.

(Hey, BLY might just gap up 10% tomorrow, but I’m not able to predict those sorts of short-term share price movements...there are others who are a lot smarter than me that might be able to do so with a degree of sustainability or reliability).


Prudent Investing I always say, but sadly I don’t think BLY fits that exhortation very well.


Good luck


Cam



ADDENDUM:
DETERMINING FACTORS OF FINANCIAL PEDIGREE

1. DEBT FILTER:
I hate corporate indebtedness.
It removes management options and strategic flexibility. I don't invest in businesses where NIBD > 2x EBITDA, or EBITDA/Net Interest <6 times (unless for extremely good reason).
I define an investment as something that puts money into my pocket, not take it out, so when companies need to come to me to repair the balance sheet because they are beholden to the whims of their bankers, then that I don't consider to be investment grade.

2. BUSINESS MODEL:
* I don't care for new concept companies, biotechs, financial engineers, explorers.
* Investment grade companies must be durable, highly cash generative (FCF must be > 3 or 4 times stay-in-business capex) with track record of free cash flow performance during economic/business downturns.
* The company's executives must be able to be the architects of my company's destiny (i.e., differentiated, unique, difficult-to-replicate products and services with the attendant pricing power).
* Customer granularity - no one customer should represent more than 5% of total revenues, and the top 5 customers should be less than 15% of total revenues.
* Supplier Independence - the company must have many alternative suppliers for it inputs, and must not be subjected to pricing pressure from suppliers (vice versa, in fact)
* Technological obsolescence threat - the company's products or services must not be subject to demand shocks due to tectonic shifts in the business/economic landscape.
* Regulatory threats - the company's products and services must be immune from regulatory pressure/threat
* Surplus organic capital generation - Investment grade companies are ones that generate capital far in excess of their internal growth funding requirements, i.e., they are scalable businesses that are able to drive up margins as revenue grows by the fractionalising of fixed cost overheads. I am not a fan of growth by acquisition. My experience has led me to coin the "5-4-1 Rule of Acquisition Growth": for every ten acquisitions that are made by corporations, 5 will destroy shareholder value, 4 will be borderline, and only one will be unequivocally shareholder value accretive.
* Transparent business model - If I don't understand EXACTLY how a company derives its revenues and profits, i.e., if I don't understand the business, I don't invest. Period.

3. ACCOUNTING QUALITY:
* I perform numerous reconciliations and cross-checks of reported Income Statement items with the cash flow statements and balance sheets.
* I conduct a range of diagnostics to discern how aggressive accounting practices are, how much accounting alchemy is taking place and hence how much prudential buffering is contained in financial statements. I have always been horrified to see how many investors take the notions of "Net Profit After Tax" or "EPS" at face value, without understanding that they are merely accounting constructs, and really are just approximations of a company's financial performance. But what people don't understand is that they are full of various assumptions on the part of the company's board of directors, its audit committee and its auditors, and like any assumptions, however well-intended, they contain natural biases and subjective interpretation of accounting standards.
* Before investing in a company I will read, from cover to cover, at least the past 5 Annual Reports, looking for warning signs or areas of comfort. Its amazing how much one can improve one's understanding of a company by trawling through the notes to the accounts, however boring that might sound. Many things provide excellent proxy clues to, such as:
- Related party transactions,
- Contingent liabilities,
- Structure and tenure of borrowings,
- Depreciation policies,
- The nature of, and changes in, intangible assets,
- The nature of, and changes in, provisioning levels,
- Changes in the elements of working capital,
- Performance (profit or losses recorded) on asset sales,
- Bad debt write-offs versus provisioning for bad debts,
- Other income

3. MANAGEMENT COMPETENCE, INTEGRITY AND ALIGNMENT:
* I look for honest, competent, engaged boards and management, who have interests that are aligned with my own.
* I look for exceptional governance practices, such as board independence, appropriate composition of nomination committees, experience set and skills distribution of board members, composition of various board sub-committees.
* I study remuneration practices, and compare these with alignment to shareholder value creation, seeking to ensure that executives my companies are not scoring fat cat salaries simply for rocking up for work, but are incentivised financially to increase the value of the business.