DEFINING WHGAs is the case for private businesses I acquire from...

DEFINING WHG
As is the case for private businesses I acquire from time to time, for me to contemplate buying a publicly-listed business, I need to be able to fully and clearly define in my mind exactly what it is I am buying. In WHG?s case, the business model has three legs: (1) Business Services (BusServ), an annuity income stream that comes from the provision of accounting services (accounting, taxation, audit and assurance, estate planning, business advisory and corporate advisory services), (2) Financial Services (FinServ), the cross-selling to accounting clients of ?wealth management? products and services (financial planning, risk insurance, self managed superannuation and finance broking services), and (3] Aggregator: WHG had ? until the GFC - been an acquirer of accounting practices across Australia.

Expanding on each of these:
(1) BusServ is a commoditised service, with what I consider to be low entry barriers. In practical terms, supply-side capacity is limited mainly by how many accountants universities and certification bodies can churn out. It?s basically a cost-plus business model, with stable and predictable margins. Critical to an understanding of WHG as an investment is recognising that BusServ is a highly seasonal business, with December half EBIT typically 75% higher than the June half. This stands to reason as the finalisation of company accounts and finalising of tax returns for any given financial year normally take place in the months of July and August (Ironically, this has a somewhat counterintuitive bearing on the broader WHG Group?s cash flows, with the JH actually being the stronger cash flow half, and the DH being essentially cash-flow breakeven, due to the Work-in-Progress build during the busier DH. As an aside, DH2009 OCF was quite an exception, with lower tax and interest payments, as well as better working capital management resulting in OCF of $20m.) Relating this business seasonality to margins in BusServ, while they are consistent between comparative periods, they oscillate from circa 14% in the June halves to ~21% in December halves. (The dispersion in margins over the past decade for each respective half around that half?s average is remarkably low, for example in the June halves the range in margins has ranged been 13.5% and 14.6%, while for the December Halves, the margin range has been similarly tight, between 20.3% and 22.2%. Needless to say, this makes forecasting future financial performance for BusServ a relatively simple task.)
(2) FinServ, like all asset management businesses that charge a fee base on a Percentage of Funds under Administration (FUA), displays a far more volatile financial nature, with higher ROA as the trade-off. While BusServ?s ROA is relatively consistent at 14%-15%, FinServe?s ROA scaled almost 45% at the peak of the equity market cycle in 2007, and even after the stock market falls to low in March 2009, FinServ?s ROA was still 16%. FinServ has done a great job of growing its business. FUA has grown from $1.6bn in 2000 to $8.7bn in 2008 at the peak of the stock market. It fell back to $7.7bn (@ June 30, 2009 balance date) in sympathy with the market?s decline, but had recovered to $8.6bn by Dec 2009. So, while the equity market is today some 35% lower than its peak, WHG?s FUA is back to peak levels. This is testimony to the stickiness of the overall revenue pot (even if fees might come under some Cooper Review type fee pressure in the future). Besides the financial planning business which generates about $50mpa in ongoing revenues and $10m in up-front revenue, FinServ also derives revenues from administering some 11,000 Self-Managed Super Funds [Revenue = ~$21mpa], Finance Broking (advising and arranging loans) [Rev =~$10m pa], and Insurance Broking [Rev = ~$7.5m pa]. FinServ is WHG?s smaller business pod, averaging about one-third of BusServ?s revenues, and EBIT levels between 25% and 55% of BusServ, depending on the point in the equity market cycle. Currently FinServ?s EBIT is around 35% that of BusServ. As is often the case with fixed cost businesses, the margin experience within FinServ has been variable, from sub-20% in the early 2000s when the business was sub-scale, to 30% during the heady stock markets of 2007, and down to 14.7% in DH08. In DH09 the margin had recovered to almost 20% again. FinServ was the star of the WHG show between 2000 and 2007, growing Revenue from less than $30mpa in 2002 to over $100m by 2007, and EBIT from $2m to $27.5m. However, the operating leverage in FinServ that served the P&L so well during the equity bull market, worked the other way during the fall in equity markets and saw EBIT from this division almost halve. This has in turn been largely responsible for the excessive de-rating of the stock, in my view, as will be discussed further.
(3) Acquisitions: While FinServe has been the organic growth story for WHG, the growth in BusServ has come from almost exclusively from acquisitions. Between 2002 and 2008, WHG spent a total of $170m on acquiring accounting practices across the country. Many of these were ?member tuck-ins?, i.e., stocking to its knitting and buying further into businesses which already had some familiarity to WHG. This acquisition strategy was eminently sensible from a value-creation point of view, and added (according to my back-testing) over $200m in Revenue and over $40m in EBITDA, i.e., a crude acquisition multiple of 4.0x EV/EBITDA. For WHG, a company that has historically traded at 7 to 8 times its EBITDA, the valuation uplift is self-evident. However, since the GFC, the company has been on a buyer?s strike, seemingly deferring to a board preference to reduce borrowings.

This deliberate and obvious pause in acquisition strategy, coupled with the cyclical headwinds experienced in FinServ, caused WHG?s earnings trajectory to stall for the first time in FY2009, after a decade of stellar growth (DH08 NPAT fell to $13.7m from $25.8m in the pcp...subsequently recovered to $16.2m in DH09, and JH09 NPAT fell to $9.0, versus $13.4m in pcp). The stock suffered a major de-rating as a result.

FORECASTING FINANCIAL PERFORMANCE FOR WHG:
In terms of FY10 earnings I am quite positive (no proprietary skiils here, just incorporating management utterences), forecasting JH10 EBIT of $20.9m for BusServ (JH09 = $19.5m, DH09 = $35.3m [remember the seasonality]), and $10m for FinServ (JH09 = $8.5m, DH09 = $9.3m). Unallocated costs are typically $10m, leaving full-ear EBIT for WHG of $20.9m. Net interest expense is likely to fall materially, from $3.4m in JH2009, $2.9m in DH2009, to $2.1m in JH2010, resulting in JH2010 NPAT of $13.2m (EPS =5.0cps) [JH09 NPAT = $9.0m (EPS = 3.4cps), DH09 NPAT = $16.2m (EPS = 5.6cps)]. Final DPS of 3.5cps expected to bring full-year DPS to 50% of full-year EPS, as articulated by management.

In my modelling of the company?s FY2011 earnings I have to make two fundamental assumptions:
a) I make no provision for a rebound in the equity market. I believe that stock market cheerleaders (notably equity market ?strategists?) are understating the de-leveraging dynamic that will continue to hamstring aggregate economic demand globally. I suspect their bullish prognosis is being driven (in a large part) by the individual stock and sector analysts at investment banks, from which the strategists build their ?macro? calls, still saying that average EPS growth for Australian listed stocks will rise by over 20% in FY11. They're dreamin', I contend, but that's a debate for a different time.
b) WHG will remain cautious in terms of acquisitions. In my mind, this is the far most pressing issue for the stock. Here?s why: After many years of easy earnings growth, it is clear to me that the WHG board became truly spooked after the GFC. During the glory acquisition years, the solvency metrics were allowed to decay to some degree ? EBITDA/Net Interest coverage fell from the mid-teen multiples in the early 2000s to 6.0x in 2009, and Net Interest Bearing Debt-to-EBITDA rose from 0.6x to 1.6x. (I feel compelled to stress that EBITDA/Net Interest of 6x and NIBD/EBITA of 1.6x is eminently serviceable and bankable, especially for a company like WHG which has negligible calls on capital relative to its organic capital generation...Operating Cash Flow historically covers capex by 7x, and by almost 30x(!) in the past 12 months as the group has effectively locked away the cheque book.)

These assumptions yield as my base case negligible revenue nor EBIT growth for the group in FY11. The biggest change in the company?s financial accounts will be seen on the balance sheet, where NIBD only my modelling is expected to fall to below $20m by June 30, 2011, from $54m @ Dec 31, 2009 (and for further context, NIBD was almost $100m as recently as the previous December balance date). That the company can reduce debt by $80m ? equivalent to over one-quarter of its current Enterprise Value - in the space of just 30 months is testimony to its financial pedigree, I'm sure most would agree. This reduction in borrowings will impact the P&L below the EBIT line in FY2011, with the Interest Expense falling to $3.6m from $5m in FY10. The result is NPAT and EPS growth of around 6%-8%. Not that exciting, and all driven a by non-operational factor.

VALUING WHG
This relatively ho-hum base case earnings outlook leaves the stock trading on (using FY2011 forecasts) 4.8x EV/EBITDA, FCF yields of 15.2% and 14.3% 9(on Market Cap and EV, respectively) and a 6.1% DY, based on a mere 50% payout ratio. The P/E is 8.4x. For a stock that traded happily during the glory days (early 2007) at almost over 25 times P/E, this must rank as the mother of all de-ratings against the backdrop of very little earnings disappointment. Sure, in business quality terms WHG is not a 9.5 out of 10 business like a WOW (for which I would indeed pay 10x P/E), or even an 8 to 8.5 out of 10 business like a REH or an ARP (also 10x P/E entry points), but 8.4x P/E is more reflective of a 3 or a 4 out of 10 business. For the record, I tend to think of WHG as 7.5 out of 10, in quality terms. So I think it is undervalued.
It warrant stressing - and this is the most critical point to note - that these valuations are set against a base case assumption of ?do-nothing?. In reality the balance sheet metrics will become so enhanced in a relatively short timeframe(by this time next year, I forecast EBITDA/Net Interest will reach 17.5x, which would be an all-time high for the company) that the even WHG's prudent and conservative board, will in all likelihood be content to resume an acquisition program of some sort. This will have the double benefit, I believe, in restoring earnings growth, and also provide scope for a higher rating on the stock as the market comes to re-appreciate the prospects for resumed earnings growth for the company. [The notion of higher denominator (?E?)combined with higher a overall P/E ratio itself is not a new or novel one; indeed there are many precedents for it. Of course, if the "E" goes up, and so does the P/E, then the "P" rises by a magnitude more.]
In the absence of renewed acquisition appetite, capital management initiatives ? most likely an on-market buyback - are highly likely given the valuation of the company and the growing franking credit balance.
So, in reality it is unlikely my base case will eventuate in 12 months? time; something else i.e., an enhancement on the base case, will almost certainly occur. I simply provide the base case as a starting point for consideration of possible scenarios.

OTHER NOTEWORTHY ISSUES
a) I always apply a range of diagnostics to financial statements in order to test the degree of accounting conservativeness or otherwise, and to check for accounting alchemy on the part of management and the company?s auditors. As opposed to synthesising profits, I find the WHK accounts to be presented with adequate prudential buffering: Cash Flow Conversion is impeccable - EBITDA divided by Net Receipts, adjusted for working capital movements, is routinely 100%. PP&E to Depreciation is less than 3x, suggesting an appropriately conservative asset life expectancy (admittedly not a big issue for an asset-light company, but still a useful proxy into management?s approach to accounting for other aspects of the business). Interest Expense always exceeds actual interest payments, and the company always provides for a very full tax rate. There is no history of losses on asset sales, and the historical bad debt experience is negligible. The balance sheet looks adequately provisioned, with total provisions at 13% of Revenue. My experience for similar companies (i.e., ?professional people? businesses, such as consultants, doctors, engineers) is that this figure tends to be in the mid-to high single-digits
b) Franking Credit Balance @ 30 June, 2009 = $46.5m (17.5cps), and given the low dividend payout ratio, I expect this will grow to over $55m (21cps) by 30 June, 2011.
c) While WHG executives and directors are not excessively remunerated, management has limited direct alignment with shareholders (the CEO owns a mere 2.25m shares, the other directors and executives own scraps) for my liking.
d) The convertible note deal with Macquarie in March 2009 is both innovative and interesting (I think).
e) As a crude sanity test of the company's current market value, the EV of some $300m needs to be seen in the context of the $170m which was the acquisition spend just in the BusServ division alone. And in terms of an alternative way of valuing FinServ, here's a personal anecdote: I owned a funds managment business at one stage, and while considering an approach from by someone who wanted to buy it, I discovered the industry norm for valuing asset management businesses was - by some bizarre logic that I today stil dont' understand - on the basis of a % of Funds Under Management/Advice (FUM/A), in my case 6.5% of FUM (that was at the height of the equity market boom, so it probably isn't representative of the new world order, I concede, but I still see businesses of the same nature trading for 3% to 4% of FUM/A). In the case of WHG's asset management business, FinServ, even using 3% of FUA would imply a valuation of $240m. Not meant to be definitive, just food for thought.


CONLCUSION
At this stage I need to qualify my investment philosophy and discipline, as I sense that I invest quite differently to most people. For starters, my Number One rule is: ? Don?t Lose Money?, so I test downside scenarios extensively before investing in a business, private or public. Which is why I am not willing to pay 15 times P/E for a business, nor 12 times, nor even 10 times (unless it?s WOW, WDC, ARP, or REH). I like to pay 7 times to 7.5 times (or <4.5x EV/EBITDA). And that?s for a business that has strong cash generation characteristics, unencumbered balance sheet, a sound business model, and value-astute and competent management. Sure it means waiting longer for buying opportunities, but unlike 99% of market participants, I am not merely buying squiggles on a chart. I am becoming an owner of a business. I also don?t sell businesses. The last time I sold out of a listed company was in 2007, believe it or not.
Getting back to WHG, I have over the years built a significant stake in the company, and I have been quite happy to add to my holdings in the past, but I don?t see the stock price being at my BUY threshold yet. Given the accident-prone nature of capital markets following the GFC, I can envisage a scenario under which the stock price falls by 10% to 15%.
But I recognise and appreciate that everyone has a unique investing style, so whether you ? or anyone - buys WHG today or not makes no difference to me. (Actually, that's not quite true. Ironically I'd actually prefer it if people didn't buy the stock, as I'd prefer it to go down so that I can buy more of it). I just enjoy sharing details of the businesses that I own with people. My businesses have given me partial financial independence at the age of 40, and total financial independence by the age of 45, and my wish for society is that more people become financial literate, and prudent, investors, so that they can at some stage get off the treadmill called ?work?, rather than hoping at some stage at the age of 67 they might be able to finally kick back and slowly tap into their superannuation.

Happy and Prudent Investing
Cameron


PS. On reflection, it occured to me that some people buy asset management businesses for A-Percentage-of-FUM/A for a very similar reason that other people are happy to buy gold stocks for on the basis of Market-Cap-Divided-By-Ounces-In-The Ground, or oil stocks on EV-Per-Barrel-of-Oil-in-Reserve, and yet others still were at one stage prepared to buy IT stocks on EV-Per-Click or EV-Per-Eyeball. Me, I need to touch and taste and feel hard cash flow. And lots of it.