mixed feelings, page-12

Acacia,

Many thanks for taking the effort to share your reservations through your very comprehensive post. I relish this kind of first-principle investment debate, as I learn a lot from it and it sanitises my own thinking.

I wish there was a lot more of it.

That way, it would help people to avoid losing their capital by undertaking sub-par investments.

I thought I would respond by way of "textual dialogue", by including my rebuttal to points you have raised, where appropriate.


To wit:


ACACIA'S POSITION:
"As a former WHG staff person I regularly talk to current and former staff and what I can say is that all is not well."

CAM'S REBUTTAL:
Yes, I know. Oh, I know only too well. I speak often to many of WHK's staff (including some so-called "principals"), as well as their customers. It's clearly not a happy place.

But that's why the stock is trading on a 10% FCF yield - AT THE BOTTOM OF THE CYCLE.

And one of the things I believe most comprehensively in, is the inevitable pendulum of cycles, be they cycles in nature, politics, economics, or capital markets.


ACACIA'S POSITION:
"WHG is merely a mashing together of a lot of former independent accounting firms to create a firm. It's an aggregator if you must, but aggregating individual firm cultures is always a difficult process. This could be papered over during the boom times but to quote a clique “The wallpaper is now pealing”. What WHG did was as you point out, is rush around and buy accounting firms at over inflated prices to create the 5th largest firm in Australia. Little heed was paid to organic growth. The people they purchased the business from were then called principals and had a handcuff placed on them for a period of time and after that time had to give 6 months notice. As time went on new principal status was given to staff and they too have to give 6 months notice to leave. I have not worked at WHG for over 3 years but it would be a reasonable assumption that all handcuff agreements have now ended and all that is required is 6 months notice to leave."

CAM'S REBUTTAL:
You're preaching to the converted. Read some of my posts where I rage against and berate acquisition-prone companies.

I am vying for the position of Most High Priest in the Church of Organic Growth in Surplus Capital Generation.

I like to think I am on the record as coining the Five-Four-One Axiom of Wealth Creation by Acquisition, which goes something like this: Of evey Ten corporate acquisitions undertaken, Five will destroy shareholder value unequivocally, Four might earn their cost of capital if the planets line up perfectly, and just One will be value accretive.

But I think you are many years too late in complaining about this. The damage had been done in the years following the mad and manic spending spree. Which ended in the first half of calendar 2008. That's five years ago. This company hasn't bought a thing since. The wallpaper peeled in 2009, 2010, and 2011 (the weighted average retention period for vendor principals was well under 30 months from time of acquisiton. This I know for a fact. So all vendor principals have been unfettered and free to compete for two years now - and, yes, many indeed have done so. But the real pain was in 2010, and 2011. This I also know from first principles knowledge. So the wallpaper is not peeling now. It has done all the peeling it needed to do some time ago. It might surprise you to learn that 18 former "principals" have re-joined the company in 2012. It certainly suprised me.



ACACIA'S POSITION:
“Accounting firms require little capital to run their business; this makes sense does it not. You need software, a computer, a desk and a chair. Accounting firms are in fact the ultimate commodity business. The only differentiator is the staff. My first accounting Job was in the late 1980’s at Price Waterhouse. I would say without a doubt the client had a relationship with Price Waterhouse not the staff. It had a brand and the client relationship extended beyond any one staff member. I can say without any doubt that this is not the case with WHG.”

CAM'S REBUTTAL:
You are absolutely right; they are capital-light businesses, which is what I like! As an investor, I hate capital-intensity...it means there's always a call on capital that take priority over distributions to us good guys (the investors). [The banks are the bad guys, in case you were wondering]


ACACIA'S POSITION:
“As the accounting firms were merely mashed together the relationship is clearly between the staff and the client.
When principals leave after their 6 months’ notice they can take with them their clients. The client has no contact with WHG and is free to go to any accountant they want. As principals are just staff they have built up extensive sick and holiday leave. They can of course use a portion of this 6 months notice on leave establishing their own new accounting firm. I can’t vouch that is has happened but I have been told that is has.”

CAMS' REBUTTAL:
Even without your being able to vouch for it, I am sure it has happened, and that it will continue to happen.

That's what you get in "people" businesses like consultancies (think AAX, LYL in the mining space and ASZ,SMX,OKN in the IT consulting space), medical centres (PRY), pathology (SGL, CAJ) dental practices (ONT), or veterinary practices (GXL).

It's a natural cost of doing businesses.

Key people leave businesses every day, and those businesses somehow continue happily on their merry ways.


ACACIA'S POSITION:
“I can’t remember the exact figures but a fair slice of WHG’s revenues comes from regional Australia, areas that have been servicing the booming mining sector and the largely buoyant agricultural sector. To top this off the SME’s still have to get their tax done every year . Accordingly, in my humble opinion the firms revenue should have held up a lot better that is has over the last 3 or 4 years. Just have a look at the explosion in SMSF in the last 12 months across Australia and WHG could only manage a 1% increase in revenues. That is less than inflation in a boom sector. Given new funds have come on board and existing funds fees would have been increased by say 5% you only need grade 4 maths to work out they have lost clients and lots.”

CAMS' REBUTTAL:
Here I must regrettably take issue with your position.

Firstly, one thing that WHK’s business most definitively is; is it is facing the really crappy sectors of the economy over the past two or three year, notably in the unambiguously struggling and economically depressed south eastern states of Australia.

But rather than get into a case of He-Said/She-Said, here are some hard facts about WHK’s geographical representation.

Besides WHK’s capital city representation, the regional office count is as follows (in order of decreasing regional office count):

NEW SOUTH WALES
Albury-Wodonga – 2
Central NSW – 7
Northern NSW - 14

VICTORIA:
Western Victoria – 13
Eastern Victoria – 7

SOUTH AUSTRALIA
Murray Darling - 8

QUEENSLAND
Gold Coast – 1
Southern Queensland – 4
Northern Queensland – 3

TASMANIA
Tasmania North West– 3
Tasmania North– 2

WESTERN AUSTRALIA
Nil. Zero.

That’s hardly a population of office locations distributed across economic boom areas of Australia.

Quite the opposite, contrary to your assertion.


ACACIA'S POSITION:
“I grant you that cashflow has enabled large debt reduction, but this was achieved by taking lockup (the time taken from when time first goes on the WIP to when the money is received) from 120 days to 90 days. This improved cashflow enormously but has little to no effect on EBIT and has soured the client relationship in a large number of cases. Further improvement beyond 90 days is not possible in my opinion.”


CAM’s REBUTTAL:
Here, unfortunately, Acacia, is where I must protest most fervently at some factual flaws in your assertion.

For the cold, hard numbers of the financial statements starkly disprove your anecdote.

For starters, Work-in-Progress as a % of Revenue [an direct arithmetic proxy for W-I-P days] has remained virtually unchanged over the period under review.

Here are the facts:

Revenue ($m):
FY08: 392
FY09: 420
FY10: 413
FY11: 406
FY12: 414

Work-in-Process (average of interim and final balance sheets, $m)
FY08: 25.3
FY09: 24.9
FY10: 23.2
FY11: 23.4
FY12: 26.9

Calculating “W-i-P days” from the above reported figures gives:
FY08: 23.2 days
FY09: 21.3 days
FY10: 20.2 days
FY11: 20.8 days
FY12: 23.4 days

So, not only has the W-i-P cycle not be been shortened from the 120 days to 90 days you cite, if anything it has gone UP over the past 2 years.

For completeness, I conducted the same exercise for Debtors Days.

It shows exactly the same stability.

Debtors Days:
FY08: 69.9 days
FY09: 69.1 days
FY10: 69.9 days
FY11: 68.4 days
FY12: 68.7 days


Next, for supreme completeness, I looked at TOTAL Working Capital-to-Revenue to make sure they weren’t leaning too hard their supplier terms.

Yet still nothing other than stability:

Average Working Capital-to-Revenue:
FY08: 16.9%
FY09: 16.2%
FY10: 15.8%
FY11: 15.9%
FY12: 16.4%


And finally, for Uber-Supreme completeness, I looked at cash flow conversion, which basically takes EBITDA, adjusts it for movements in working capital as well as changes in provisioning levels, and comparing the result to Net Receipts on the cash flow statement.

The results are exemplary:
FY08: 110%
FY09: 90%
FY10: 96%
FY11: 102%
FY12: 103%

That’s about as “clean” a reconciliation you can get.

No matter which way I slice or dice it, what is clear to me is that there has not been any one-off boost to operating cash flows through the liberation of working capital of any sort, as you had asserted.

Quite the opposite, in fact.

There’s been a small working capital investment, which has been a slight Operating Cash Flow head wind.


ACACIA'S POSITION:
“I admire your FCF approach to investing Cam but you also have a good business with a good moat. WHG is not that in my opinion.
It has no moat and is losing lots of clients. Given my telephone conversation with someone who was working at WHG as recently as November the situation would appear to be getting worse. This may or may not be reflected in the half year results but they certainly will be in the full year accounts.”

CAMS' REBUTTAL:
I reckon it’s a 6.5-out-of 10 business, trading on a 10% FCF yield, predicated on cyclically low trading conditions.

Like I said before, the cycle has been very deep and very long for these guys, which I don’t think most people appreciate. Many other businesses would be extinct if they had a similar business environment.

At some stage in my remaining lifetime, I think the cycle headwinds will become tailwinds again.

As for speaking to people within organisations, I normally discount what I am told when it comes to professional fulfilment and sentiment. I remember working for a company once (a publicly-listed cement manufacturer) and when I joined a stockbroker some years later I was shocked to hear analysts and fund managers describe my former employer as a world-class, highly desirable company in which to invest. All I saw from the inside when I was there was office politics, bureaucracy, inefficiency and low morale.

I often get that sort feedback socially when people who work for Telstra or CBA can’t believe I would invest in their employers given their adverse first-hand, day-to-day, working experience. I think you get that with every company.


ACACIA'S POSITION:
“Just my humble opinion but this is a business in serious decline and it is a total AVOID!!!!”

CAMS' REBUTTAL:
Understand you concerns, and thanks again for sharing them. I guess one needs to define the “serious decline” of which you speak.
You seem to think it is structural.
I believe it is merely cyclical.

And, as I said, I am getting paid 7% pa while I wait for the cycle to recover.