invitation to madamanswer to comment, page-21

A sure thing investment? You would have to describe what the "sure thing investment" means.

I'll give you a nice, home-grown advantage of what I mean by a sure-thing investment.

Fast forward to some point in the future when - hypothetically - MSB has finally received approval to manufacture and market its products for RA.

Now assume, for the sake of argument, that the company has sufficient capital to fund its working capital ramp-up to support growth in sales arising from the demand from the major unmet medical needs which MSB seeks to address.

Now assume the company at that point (Year 0) generates US$100m of sales (in the context of the size of MSB's addressable market, Sales of US$100m is eminently achievable, even at a relatively early stage of commercialisation, I'd argue).

Then, assume the following financial parameters, which I would expect from a business such as MSB, once it reaches commercial self-sustainability (namely: high barriers to entry leading to significant pricing power and therefore high gross margins, capital-light business model with manufacturing and distribution being outsourced):

- Gross Margins: 70%
- Cost-of-Doing Business Margin: 20%
- Capex-to-Sales = 5%
- Capex-to-Depreciation = 1.0
- Tax Rate = 10% (MSB has Accumulated Losses on the Income Account approaching $350m, so it won't be paying any meaningful tax for many years after, or if, it becomes profitable one day
- It is assumed - for simplicity - that all surplus capital that is generated, is retained.
- Interest Earned on the surplus capital balance = 2.5%


I won't go into the detailed machinations, but the company's P&L in this hypothetical Year Zero would look something like (all figures in US$m):

MSB's "Year Zero" P/L:
Revenue = 100
Gross Profit = 70
EBITDA = 50
EBIT = 45
Pre-Tax Profit = 45
Net Profit After Tax = 41


Next step is to assume the rate at which MSB might be able to grow its Revenues.

Given the relatively easy scale-abilty of the business model, and given the hypotheticall significant structural demand for the products in question, the only impediment to growth will be the supply chain, so I've assumed a quite conservative Working Capital-to-Sales ratio of 30%.

But despite that limitation, I still believe Revenue growth of 15%pa would be achievable, especially in the early years, due in part to the small starting base effect.

On that basis, and given the operating leverage through the P&L, MSB's annual NPAT growth will average between 20% and 23% for the next 5 years (5 years being a typical investment time frame of investors like myself).

In the interests of brevity, I will exclude the pro forma P&Ls for Years One to Four (readers who are real purists about these sorts of things can derive them themselves, based on the assumptions I've used), but the P&L for Year 5 would look as follows:

MSB's "Year Five" P/L:
Revenue = 201
Gross Profit = 141
EBITDA = 118
EBIT = 108
Pre-Tax Profit = 115
Net Profit After Tax = 104


Now, investors like me (aka the nervous, risk-averse nellies who simply don't understand that MSB is different) would wait until Year Zero (when the company is commercially self-sustaining) before we invest in MSB.

Now, assume that we are forced to pay a massive 40x P/E multiple (which translates into a 32x EV/EBITDA multiple).

[Note, 40x P/E would be one of the highest multiples of any ASX listed stock, and would be higher than CSL's 35x multiple, and a lot higher than other health care darlings listed on the ASX, such as RHC (27x P/E) and RMD (25x P/E)]

Applying a 40x P/E multiple to $41m of NPAT in Year Zero, would place the company on a market value of over US$1.60bn (i.e., A$2.1bn). That's more than double its market value today.

So, the Johnny-come-lately investors like myself would have to pay more twice as much for for the value of the business than we would do if we bought shares today (note, not double the share price, because that depends on much further dilution there still occurs between now and the hypothetical Year Zero, the year of self-sustaining commercialisation).

But, based on the increase in the intrinsic value of the business between Year Zero and Year Five (witnessed by the 2.6x rise in profitability over that period), the value of the business would have grown to almost $4.2bn (assuming the same P/E multiple of 40x, applied to $104m of NPAT).

For those that prefer to think in terms of annual investment returns, that works out to a compound annual return of 21% pa. (!)

And 2o%-plus pa returns - as anyone who truly appreciates the power of the compounding effect - is the stuff of serious wealth creation.

Of course, some of my assumptions might be wrong (making financial forecasts for the next 12 months is difficult enough a task to get right; forecasting financials for a five-year period beginning at some indeterminate point in the future can, at best, only be indicative and not prescriptive.)

But even if I assumed incorrectly, and Revenue growth ended up being a very modest 7.5%pa, and Gross Profit Margins of a mere 60%, the resulting annual investment returns drop to a still-acceptable 12% pa.

(On the bullish side, if Revenue growth turned out to be 20% pa, which - though not very probable - is not impossible nor inconceivable, then the resulting annual return starts to come in somewhere in the mouth-watering range of 25% and 30%).

PS. Of course, one needs to contemplate the scope and possibility for de-rating of the valuation multiple over time. With that in mind, even if the P/E multiple after Year 5 was 25 times (which would correspond to a truly massive de-rating and would leave the stock's multiple at a lower level than its listed peers, so it is not a outcome that I consider would be very likely), the resulting return would be 10%pa. Which is not stellar, but it is still positive and in line with long-term equity market returns, so not too shabby for a downside scenario, I like to think.

No matter how it is cut, sliced and viewed, if MSB reaches the point of commercial self-sustainability one day, it will be a financial powerhouse, and will make for a fine long-term investment.

But in my opinion is only once - and if - it reaches commercial self-sustainability.


And so, @alhambra, to answer your question: considering the scenarios above for MSB, there's an example of what I believe would constitute a "sure-thing investment".

A business that, even if you buy it on a very full valuation multiple, will generate above-average investment returns for you.

I am sure you will agree.

(Of course, the scenario of what happens if commercial self-sustainability is never reached is the binary opposite of the above, namely negative investment returns and the permanent impairment of invested capital. And permanent capital impairment what I seek to avoid at all times.)


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