Stefanis/MMennell,Apologies for reverting only now, but I have...

Stefanis/MMennell,

Apologies for reverting only now, but I have been abroad for 3 weeks, with limited interest in accessing the internet.

You asked some time back about preferred valuation methodology and entry levels for ARP and REH.

Let me preface discussion of my investment process by saying that I invest with a "business owner" mindset, i.e., I "pretend" I am buying the entire business with the view to harvesting the cash flows, which I then deploy towards fresh investments (i.e., buying other undervalued cash flow streams).

So FCF/EV is my most critical valuation measure. In other words, my thinking is this: "if I buy a business buy paying the equivalent of its EV (and buying the entire business should be no different, in investment theory, to buying just a share of the business), what % of my outlay will I be getting back each year?"

Naturally, I am constantly seeking to minimise my payback period. A ten-year payback is my absolute limit, i.e., FCF/EV >10%.

If a stock fails on that valuation filter, then the discipline of my investment process makes me wait.

As a secondary measure I use EV/EBITDA (which is really a cruder version of FCF/EV, except that it overlooks the cash flow impacts of non-operating elements such as interest expense (or earned), tax payments, and working capital requirements.

And yes, you're right Stefanis...FCF/EV > 10% & EV/EBITDA <6 are the BUY trigger levels of my investment process.

[I feel that I should stress the phrase "investment process", because I feel very strongly about having as strong as possible an investment discipline that is contained within the framework of some systematic process. The reason for this is to remove as much of the human elements (i.e., moods, sentiment and emotion) out of investing. I don't trust human emotion when it comes to investing. And indeed, this entire HC site is riddled with emotion and human nature...just reading a few random posts will confirm that for anyone who doubts it! Successful investing is not emotional, it is mechanistic. Ask Warren Buffet, Peter Lynch, or even Bill Gross (the "Warren Buffet" of the bond market).]

But back to ARP and REH. To buy these stocks on FCF/EV >10% or EV/EBITDA <6x is virtually impossible to do, simply because these stock prices essentially never fall to such valuation levels. And the reason for this is that they are unique entities, and markedly different from the 99.9% of all other listed companies. You see, these are true "growth" businesses.

Now, while many company executives make ambit claims about the broad notion of growth and the pursuit of growth, very few companies do actually achieve true organic growth on a sustainable basis.

By far the majority of growth from listed equities can be classified one of four ways; either:
- cyclical in nature (eg. media, commodity stocks, building materials),
- based on a roll-up strategy (i.e., acquisition-based, e.g. CPU, QBE, SHL, TOL, WES, ),
- predicated on strategic or operational turnaround situations (ALL, BXB, CRG, DOW, FGL, PRY, SUN, TLS), or
- based on ongoing recourse to shareholders for capital (i.e., periodic capital raisings to fund the growth, implying growth in absolute nominal NPAT, but diluted away at the per share (EPS) level).

These might all pass the broad definition of "growth", but none of it is high-quality, internally-funded, sustainable and recurrent organic growth.

Investing in cyclical growth is tough...it is predicated on correctly calling commodity prices, exchange rates and interest rates. I see a whole industry of phD-trained economists who can't get these macro calls right; any small investor who claims he can do so reliably enough to stake his financial future on it is probably being a bit disingenuous with himself in my opinion. That's why I don't invest in mining stocks....when the managers of a business to not get to determine their own price list, I'm not sure how durable that sort of business can ever be from a shareholder value creation standpoint.

And I am always dubious/sceptical about the kind of earnings growth that is driven by roll-up strategies, i.e., serial acquisition. My long-held observational experience is that the value that gets created by acquisition is tenuous, at best. I call it the Five-Four-One Rule...for every TEN acquisitions that are made by corporations, FIVE will unequivocally destroy shareholder value, FOUR are probably value-neutral, and just ONE creates value for the shareholders of the acquiring entity.

Similarly, the promise of turnaround stories: I think creating wealth for oneself by second-guessing turnaround timing and quantum is very hard, and invariably takes longer than anticipated and generates all sorts of disappointments and false starts.

Only a handful of companies I have found truly fit the mould of the pure "growth stock". These are companies that have the following attributes:
? business model scalability
? pricing power,
? low capital intensity so that all growth can be funded internally,
? granular customer base,
? supplier reliability,
? credentialisation of industry partners
? management team who understand and practice reinvestment above cost of capital

The list is far from extensive...in Large Caps: ASX, CCL, COH, WDC, and WOW; and Small Caps: ARP, BRG, CPB, DTL, IVC, REH, RMD, SAI, SDI, SEK, TWO and WTF.

For these sorts of stocks a different valuation approach is necessary, specifically a Net Present Value (NPV) obtained from the discounting of future free cash flows.
Now valuation theory will teach that NPV's are fraught with assumption errors, notably in the forecasting long-term cash flows. So what I do is I only explicitly forecast future cash flows out two years, and the add the present value of those two-year cash flows to the terminal value cash flows, derived from the formula:

T = Y2,FCF/(WACC-g),

where T is the terminal value of the cash flows from Year Three to perpetuity,
Y2,FCF is the Free Cash Flow in Year Two,
WACC is the Weighted Average Cost of Capital (normally between 9% and 12%),
and g is the long-term FCF growth rate.

Best way to illustrate this is by way of example, using ARP. For ARP, my FCF forecasts are as follows:

FY10 (actual) = $32.9m
FY11 (forecast) = $29.8m (the reason for the reduction on FY10 is because I anticipate working capital to rise due to a need to fill the expanding distribution pipeline as the new Thai manufacturing plant increases output
FY12 (forecast) = $35.5m

ARP's WACC I estimate to be about 10.5% (essentially its cost of equity given the company makes no use of debt capital), and the long-term FCF rate I believe can be maintained at 6%pa)


So, for ARP, the net present value of the terminal (Year 3 and beyond) cash flows is given by:

T = 35.5/(0.105-0.06) = $790m, or $730m in today's terms (after discounting by the inflation rate of 4%pa)

Add this to the NPV of the cumulative FCF next two years, which is $62m, to yield an NPV of some $790m

This compares to ARP's current Enterprise Value of $500m (Market Cap of $520m less $20m net cash holding)

So, by my reckoning ARP is trading at a 35%-40% discount to my assessment of its NPV of FCF.
So while it looks reasonably fully valued on near-term (FY2011) valuation metrics (FCF yield of 6.2%, EV/EBITDA = 9.1x, P/E = 15.1x and DY = 5.2%), on longer-term valuation measure (Discounted Free Cash Flow) the stock is still significantly undervalued, in my opinion.

A Sanity Check:
One way to test the veracity of the target price is to solve the equation for the long-term FCF growth rate as implied by the current market value of the business.
In the interests of brevity, I will omit workings (unless anyone explicitly requests them), and give the answer as 2.9%pa.

In other words, the current share price is saying that ARP will only be able to grow its FCF by less than 3%pa going forward. For a company that has historically grown FCF at rates approaching the mid teens, I think it is fair to say that 3% is laughable. Certainly, I am willing to stake my children's future (indeed I already have) on 3% being exceeded handsomely.

For the record, REH is only about 10% undervalued using this NPV methodology (for the record, for REH I use a long-term growth rate of 4%).

Hope this helps.

Cameron