exceeded even my own lofty expectations

Fellow - and aspirant - SGN shareholders,

To me reporting season is akin to a university exam for which we study and research in the preceding six months. For some exams I do less well than others (for example, I scored an "F" mark for the MYR exam). However, I am pleased to report that my report card has a distinction recorded against SGN.

There is a lot to like about our company's result; indeed, on many measures it exceeded even my own lofty expectations.

While most broker reports I read today reported that the company had modestly exceeded their NPAT expectations, I tend to look far beyond just the accounting oddity that is "Net Profit"...I try to look more deeply at the underlying quality of the result; how conservatively struck the accounts are, how much prudential padding is contained in the financial statements.

For SGN, this result bears many hallmarks of:
* a business model that is robust and durable
* a company that is humming, operationally, and
* a management team that is commercially astute, operationally competent, and shareholder-value savvy.

For starters, the result quality is beyond doubt:
* Adjusting for movements in provisions suggests reported EBITDA is understated by around 3%
* Cash flow conversion was at a record high: Net Receipts-to-EBITDA was 115%
* PP&E-to-Deprecation in the DH was 3.1x (i.e., fixed assets are written off over 3.1 years, which is harsh, even if the PP&E is mostly of a technological nature). This is the lowest rate of depreciation recorded by the group.
* Interest expense-to-Interest Paid was 180%, a clear indication that no interest has been capitalised

This all points to conservatively presented P&L, i.e., had the Audit Committee and the auditor wanted to be a bit more "racy", operating earnings could easily have been reported $1m or $2m higher.

But the standout feature of this result, as had been flagged on various SGN threads over recent months, is the accelerating rate of FCF generation (pre-earn-out payments, which are non-recurrent to perpetuity, and should therefore be ignored for purpose of pro forma read-through) of $82m ($45m in the December half). For context, on Market Cap of $536m, this translates into a FCF yield of 15%, and even in including all deferred consideration obligations into the derivation of EV, the FCF yield on EV is 13%.

And one needs to qualify that nature of SGN's FCF: it is highly resilient given OCF far, far exceeds Stay-in-Business capex (normally by a factor in the high teens, which would be a metric in the top percentile of listed companies, I sense), and FCF as a % of Revenue is above 25% (in the December half , it was 29%...29c in each dollar of sales reporting to the FCF line is one of the highest I have encountered, which is testimony of a high-margin, capital-light business).

Behind this FCF performance is extraordinary working capital management, to wit: trends in Working Capital-to-Revenue are as follows:
DH08: 8.1%
JH09: -0.9%
DH09: -1.7%
JH10: -4.9%
DH10: -10.6% (!!!)

The outworking of this is a dramatic rate of decline of Net Debt, that has exceeded my expectations by far:
Net Interest Bearing Debt:
JH09: $75m
DH09: $72m
H10: $ $47m
DH10: $34m

And that's despite the company having made payments totalling $46m in dividends and $50m in earn-out payments and acquisitions over that period.

December half 2010 NIBD/EBITDA was at 0.4x (June half = 0.7x), and EBITDA/Net Interest for the December half was 7.5x (June half = 5.3x)

On my modelling for 2011, NIBD/EBITDA will remain at around 0.5x, and EBITDA/Net Interest will remain over 8 times, DESPITE the further $32m in earn-out payments.
This year is the peak for earn-out payments; beyond 2011 the obligations drop off sharply.

Hence the dramatic increase in the dividend payout ratio, and the capital management agenda now being highlighted (I thought it a distinct possibility at some stage, but not quite this soon. That it has been brought forward is testimony to both the cash flow outperformance, as well as the keen understanding on the part of management as to what drives shareholder value).

[As an aside, RainMaker I know that you are critical on the management for raising capital at 48c during the throes of the GFC. My rebuttal to that is that the CEO knew that many of the agencies in which SGN was a minority investor were struggling due to the slump in advertising at the time and that he would have been able to capitalise on some seriously distressed vendors. If he had raised capital at such a discount simply to sit on it, then you criticism is well-founded, but I think the reason that SGN is performing so strongly at the moment is because the businesses that were bought at the bottom of the cycle are now performing at far more normalised levels of profitability. And while I am typically not a fan of acquisition strategies per se, these were low-risk acquisitions given SGN knew the businesses they were acquiring intimately by dint of their historical shareholding. At the time of the raising, CEO Connaghan said he wanted SGN to move from an investment holding company to a holding company. To my way of thinking, he has walked the talk perfectly. If he wants more capital to embark on a similar value creating corporate strategy, I for one will gladly reach for my cheque-book. Although I stress that the health of the balance sheet and the strength of the cash flow will mean that he is unlikely to need recourse to shareholders for capital.]

I summary, this was a simply stellar, clean, and conservatively-stated result, and the outlook for the company is positive.

Combined with a capital management debate, that the company can give earnings guidance when their profitability is skewed to the December half I think is a clear sign of how confident they are in the ability of the business to continue performing very well.


Best wishes

Cam

Sarcastic footnote: I find it quite bizarre that SGN records similar type of profits as something like Independence Group (IGO.AX). Yet IGO?s Enterprise Value is more than double that of SGN.

O Tempora, O Mores