discussing valuation

This is my first post on hot copper. My background is fund management. I no longer work in the area but trade my own funds from time to time.

I have made what is a large investment for me at ave. 47c in ISD.

I think the market is missing the point now on valuation, or the professionals are playing this to get it lower before loading up and pushing higher. I think there are similarities with the recent move in SWM from a lowe of 49c or so (hit $1.1 2 days ago).

SWM endured longer period of pressure on share price with profit downgrades against a background of high debt load. They cut the dividend and that signaled that debt would start to be paid down. This was and is way more important in such scenarios than maintaining a dividend to placate retail shareholders. The professionals know this! Equity will not be driven up whilst there is a risk of a large dillutive cap raising.

ISD was valued as a growth stock because of a strong leading market position in a cash generative business and growth opportunities in Asia. It screwed up royally with the content media acquisition and other missteps and has lost over 90 percent of its value. History.

What is it worth now?

1. Current market cap: $83m
2. Net debt: $43m
Enterprise Value (1 + 2) $126 million

They have guided to $120m sales and (I am extrapolating) $23m ebitda in the coming year. Approximately 20% ebitda margins. These are good margins by the standards of most industries but poor compared to their margins in recent years, reflecting competitive pressures and mistakes made. So, the stock is currently priced on an ebitda multiple of 5.5x which is low compared to market averages and very low for stocks with these ebitda margins unless you believe the company is ex-growth. I do not believe the company is ex-growth.

They still have a leading or good market position in markets with growth potential (Asia in particular of course). They have strong proprietary technology. They have 79% recurring revenue, which many companies would die for, although this needs to be protected. They have geographical spread. The business is inherently cash generative. This is an important point, because even in a weaker business environment, such as they have faced recently, they can pay down debt materially.

If we assume they have annual depreciation and amortisation of around $5 m (last year it was higher at over $8 than the previous year's 3.5m for one-off reasons), then the business should earn $18m of operating profit (EBIT) on its forecasts for a 15% EBIT margin. A rule of thumb (crude) is that such a margin would warrant around $180m of Enterprise Value, $54m higher than Friday's value. To get to that implies a share price 65% higher or 68.5c.

Should the stock trade at these levels? The argument against is obvious. It has continually disappointed in recent times and there is nothing to say it won't do so again. So, the theoretical valuation of current metrics will justifiably be discounted.

The real question is what is now reflected in the price of the stock. I think cutting the dividend is a real plus. The ability to continue to pay down debt will be a strong driver of the equity value from this low base. Estimating an interest and tax burden of $7m (2m + $5, which may be on the high side), and cash investment needs of $5m, they should be able to pay off another $11m in the next year, leaving net debt at just over $30 million. At the same time they are pursuing significant cost cutting initiatives which should provide some greater confidence that ebitda estimates will be met at least.

On current forecasts, which I would tend to view as trough earnings, I believe the theoretical value (my theoretical value I hasten to add) should be discounted by about 20%, meaning I think it should trade now at about 55c, and this should represent a very conservative valuation. Even if they don't see an improvement in sales and margins in the following year, the equity value can grow appreciably as the market sees them pay down debt, reducing the enterprise value and alleviating concern over gearing.

However, I think the company is more likely able to post some growth from this much lower base, both in revenue and in margin. Only modest revenue growth combined with the projected cost savings could see EBITDA rise back to $28m easily in year 2. If, by that stage, the company has approx $32m of net debt then the implied enterprise value of $115m at today's prices gives a forward looking EBITDA multiple of just over 4 times and an EBIT multiple of 5 times. This company, cash generative as it is with leading positions, would trade at a minimum of 10x EBIT in a normal environment where revenue and profits are growing. So, I think if we are indeed at a realistic guidance level with modest growth possible and cost saving happening, the stock could and should very easily double in the next year. I think the professionals now know this and will position themselves for a move up. The interesting aside to this is that it is rare that leading companies in cash generative growth markets get priced at these levels and this makes it a takeover target. Investor sentiment is at an all time low. The management are discredited. The company has exited its problematic business. Cost savings are in motion. A trade buyer (competitor) or private equity could justify paying a price of 68c or higher and still view this as an extremely cheap price on forward prospects. In the event of a bid I think the absolute minimum would be around 80c (where it traded just 2 days ago) to $1.

In my view the worst case scenario is now baked into the share price and there is very significant upside.

This is just my view. I have taken a good position in the stock, so I am talking my own book of course.