Persist/Stefanis,Thanks for the robust debate that is grounded...

Persist/Stefanis,

Thanks for the robust debate that is grounded in somewhat more rigour than HotCopper's usual "the-buy-side-orders-are-stacking-up-nicely-so-the-stock-looks-like-it-wants-to-go-up-this-morning" or "my-stock-is-going-down-not-because-I'm-an-idiot-but-because-of-those-damn-bots-and-manipulators".

I suppose I might be guilty of not articulating my WHG thesis well enough, and I concede that the company has not exactly been an ARP, or a BRG, or a CCL, or a RHC in terms of its financial performance these past few years.

However, I think that, as is always the case, some context is useful:

If one considers than this company has been at the most hostile forefront of the weakest parts of the Australian two-speed economy over the past few years, namley as a service provider to SMEs, then I think it explains some of the deterioration in financial performance.


Specifically:

EBIT for the Business Services segment (i.e., accounting and advisory services to SMEs) has fallen from a peak in excess of $50m four or so years ago, to around $30m today.

EBIT for Financial Services (i.e., the wealth management and financial planning division) has fallen from a pre-GFC peak of $25m, to 415m today.


That this company has been through the mother of all business storms, that has endured for almost 4 years now, is no overstatement.

However, given how deep and long the dowturn has been - and remember the nature of WHG's business is that it is directly exposed to this sort of financial "crisis" - I actually think the business has peformed very well, and is testimony to a resilience for which I think you are not affording it due credit.


Let me sxpand:

Like many of these situations of earnings discontinuity, the Cash Flow performance tells a story that is a bit different to the P&L narrative.

Yes, revenue has been pressured and, yes, the operating leverage in the P&L has meant that accounting profits have been crunched.

But I look at the balance sheet and I see a company that at 31 December 2008 - the heart of the GFC - had Net Debt at close to $100m.

Today, despite a prolonged period of acute downturn in business conditions, WHG's Net Debt is less than $50m ($41m @ 30 June 2012).

Importantly, that balance sheet repair has been achieved with nothing other than Organic Surplus Capital Generation...no equity raisings were needed and no net assets sales took place.

And, most strikingly for me, dividends didn't skip a beat over that time frame.

Put in hard dollar terms, since the GFC (i.e. post-FY08), WHG has:

- generated $115m in Operating Cash Flow,
- reinvested $16m of that back into the business,
- distributed $55m to shareholders, and
- reduced Net Debt by $58m

Remember: no new equity, no selling of the farm...just sheer internally generated cash flows.

[Note: While the company lists "Lease and Hire Purchase Payments" under the Financing Cash Flow section of the cash flow statement, I consider these to be of an Operating Cash Flow nature, so the $115m figure above includes Lease and Hire Purchase Payments of around $5m pa.]

That this company was still able to - during an undeniably challenging period - RETURN TO SHAREHOLDERS, CAPITAL EQUAL TO A FIFTH OF ITS CURENT MARKET VALUE, WHILE AT THE SAME TIME HALVING NET BORROWINGS, I think is a most telling part of the WHG investment rationale.

Inferior quality business models experiencing a downturn of a similar severity might easily have gone to the wall, or at best cut dividends and issued fresh equity.

My belief is that at some stage of my remaining life time the business cycle for WHG will turn favourably, and the company will go back to generating EBIT double today's depressed, bottom-of-the-cycle, scorched earthed levels.

In the meantime, I'm getting paid a 7% fully franked dividend while I wait. (A franking credit balance of $50m means that WHG can pay out more than it earns for several years to come).

My concern has for some time been that someone with a far bigger balance sheet than mine - and who thinks like I do about economic and business cycles - comes along and buys the company from me before it has chance to rise inevitably to its former glory.

And that sub-optimal scenario looks exacly like it is coming to pass, I'm afraid.


Thanks for the intellectual engagment.

Cam


[PS. Stefanis, I stand my descriptor of a balance sheet in "fine fettle":

When net debt is equivalent to:

- around 4 years' worth of bottom-of-the-cycle free cash flow, or
- a little more than one year's bottom-of-the-cycle EBITDA, or
- when EBITDA-to-Net Interest is around 7 times,

...then I sleep quite easy at night, especially considering the "capital-lightness" of the enterprise.]