[This post is in response to a question raised on the ASZ thread...

[This post is in response to a question raised on the ASZ thread by MikeMennel]

Mike, I suspect we have differing understandings of "ringing the bell". In my lexicon it means that the stock valuation is within my buying limits.

Are you asking me at what price level I consider the RISK-RETURN relationship to be favourable enough to be buying CDD?

If that's what you're asking, then sub-400 would be my entry price. At that level the stock's valuation metrics (on my FY2011 forecasts) are:

FCF Yield (on EV) = 10.5%
FCF yield (on Market Cap.) = 11.8%
EV/EBITDA = 5.6x
DY = 7.0%
P/E = 8.5x (9.4x, on tax rate normalisation)

There are some aspects to CDD that shape my thinking. Firstly, like AAX, COF, LYL, and even WOR to some extent, CDD is a technical consultancy business, and these tend to demonstrate lumpy revenues. The distinct nature of their businesses is a lack of customer granularity, and the need to constantly replenish the order book which, in turn is largely a function of the external environment, and not something which managers of these businesses can dictate not control. And no matter what some might seek to argue, these services are largely commoditised and the real thing that is being sold here is time. So, I don't believe any valuation multiples that come close to a premium to the broader equity market is appropriate. Of course, I've heard cheerleaders of CDD et al point to the low capital intensity and high free cash generation of that these businesses. True, but when revenue evaporates, as it does at least once per business cycle, so does the free cash flow, irrespective of how asset-light the particular business might be.

The other point of niggle I have with CDD is getting a grip on how much value, if any, has been created by the sheer acquisition orgy that CDD has been on over the past five years, and still continues to pursue. Look at the hard numbers:

Since 2006, CDD has made some 15 acquisitions, totalling more than $360m. In the process, the company has raised almost $230m from the equity market. Issued share capital has risen sevenfold over the past five years, while forecast NPAT in FY11 will be a mere three-and-a-half to four times higher than the start of the company's acquisition spree. Put another way, assuming (somewhat harshly) that the residual CDD business demonstrated zero organic growth over the past five years, then the $365m in acquisition has added some $35m to net earnings (FY11 NPAT forecast of $46.5m versus FY06's $12.7m pre-abnormal NPAT), i.e., on my back-of-the-cigarette-box calculations, they have averaged acquisition multiples of ~10.5x . While this is an admittedly crude exercise, and intended to be indicative, rather than prescriptive in its results, it does not demonstrate unequivocal value creation, to my way of thinking. Overwhelmingly most of the acquired businesses were privately owned, where transaction multiples are typically in the mid- to high single digits, but very seldom do they reach double digits.

And the trouble I have with buying CDD now is that 30% of future EBITDA comes from a set of acquisitions that have just been concluded (notably Entrix, ITC and Environmental Solutions), meaning that's 30% of EBITDA that I have not been able to put through my quality tests, i.e., how reliable is that earnings stream, what are its margins, how much working capital will it need to support it, how resilient will it prove to be during a possible business downturn. It simply introduces for me an element of uncertainty, and my investment philosophy is based largely on elimination, where possible, of the known unknowns from the investment thesis. One can never be 100% fully informed, but one can, and should, invest where one is best-informed. It's all about neutralising risk as far as possible.

(As an aside, I tend be wary of companies that are run by serial acquirers. I happen to think that creating shareholder value by acquisition is a very difficult thing to do: integration complexities are often underestimated and stated synergies are often competed away. I know of few companies that can demonstrate clear shareholder value creation through acquisition, to name a few: CPU, QBE, WES [I believe Coles will continue to surprise in its turnaround momentum and more than earn its cost of capital], and among the small cap sector, MND, COU, CPB, SLM, SGN, and WHG.)

But back to CDD, there are also a few accounting tricks of which I am sure you will be aware; the most pressing one is the light tax expense in recent reporting periods. Tax rate over the past 4 financial half-years has been 23%, 11%, 16% and 12%, respectively. The reason for this is largely due to some major R&D allowances, and also the reversal of overprovision in prior years. While this obviously has no bearing on the operating performance of the company, it does however, mean that when followers of the stock quote a P/E multiple, it is really understated by a multiple of around 1.0. Now I have not made a definitive assessment of what the R&D allowance will look like going forward, mainly because all R&D expenditure seems to be expensed (which I like...it is a nice, conservative practice), and the notes to the financial accounts are silent on the quantum of R&D.

Other than this the CDD financial accounts hang together quite well notwithstanding the perpetual acquisition frenzy; cash flow conversion is in the upper quartile of companies, the interest expense on the P&L is almost double the physical payments per the cash flow statement, which is indicative of an absence of interest capitalisation, and PP&E is written off over 3.7 years, which still looks conservative enough, even though it has been trickling up in recent periods from 2.4 years.

In summary, I see CDD as a 6.5 out of 10 business under steady state business conditions, and with a track record of earnings under the belt. Add in the vagaries inherent in any global acquisition foray, and I believe you're really left with a 5.5 out of 10 investment situation. And the trouble is, at its current market cap, CDD is valued somewhat like an 7.5 out of 10 business, in my view. I am into the business of avoiding loss as much as possible, and at current price levels, for CDD I think the downside risk-to-upside potential is too evenly distributed for investment discipline.

Hope this helps.

I recognise fully that I invest far more cautiously and with far greater patience than most investors, so I'm not trying to convince anyone that my investment philosophy is the definitive one. It's just that I have found over time that it helps me sleep well at night.

Prudent Investing

Cameron