The peak week for reporting season has a been a good one for plenty of companies owned by Montgomery funds. Continue reading
That business is ARB Corporation (ARP), and its compelling fundamentals are the reason we have held the company’s shares in the Montgomery Private Fund since inception.
Those fundamentals have also helped to produce acceptable results for Montgomery investors (See Figure 1) amid an otherwise manic, depressive market.
Guided by its founder, Roger Brown, ARB designs, manufactures and distributes accessories for 4WD and light commercial vehicles – something it has focused on solely and successfully for almost as long as I have been alive.
And while producing and selling accessories for 4WDs doesn’t sound like an overly exciting business, consider the fundamentals over the past 10 years.
Since 2002, ARB has managed to grow its after tax earnings from $8.36 million to $37.8 million – a compound growth rate of 18.25% per annum. This is a fantastic achievement and largely organic because it has required just $133.5 million of retained profits and equity – the latter from the issuance of options.
In 2002, $8.36 million profit was generated on $31.2 million of shareholders’ equity, generating a return to owners of 26.8%. Fast forward to 2011 and returns are equally impressive. $37.8 million is being generated on $129.3 million or 29.2%. Many businesses have also grown their profits over the same period of time, but it is far more often that growth has been ‘acquired’ and declining return on equity suggests those acquisitions have been expensive.
Fig. 1 Results are net of all fees.
As the business has grown and developed its economies of scale, returns have actually improved. This is a rare achievement in practice and a development which creates significant value for shareholders.
If you were a part owner of the business in 2002, your shares would have grown steadily in value (not share price) from $1.91 to $8.09. If you believe Benjamin Graham’s observation that in the long run, the market is a “weighing machine’, then you must agree that prices follow valuations over the long run. Provided you can see which businesses are able to increase their per share intrinsic value, there is no longer any need to try and predict share prices! Simply buy high-quality businesses – with rising intrinsic values – at discounts to that intrinsic value.
Figure 2 reveals the change in the ARB’s valuation mapped against its share price over the last decade.
Fig. 2 Skaffold Line ARB and its Intrinsic value 2002-2014*
*Source: www.Skaffold.com 2012-2014 valuations are estimates
(If you have been thinking about becoming a Skaffold member, having a chart like Fig 2 above for every listed Australian company and a chart that is updated automatically and daily coming up to a Greek election, a Spain bailout and a very crucial reporting season is more than just a little helpful. I find it essential. So if you are thinking about a membership to Skaffold, go to www.skaffold.com and take advantage of the 13-months-for-the-price-of-12 “It’s Time” celebration promotion (and be sure to chat to your accountant about any pre-June 30 tax benefits)).
This represents a total value increase over the period of 353.93%. Including $1.76 in fully franked dividends, the business has generated a total return over the past 10 years of 446.1%. Suddenly selling bull bars gets a whole lot more exciting doesn’t it?
ARB Corporation’s rising valuation and share price clearly reflect the high-quality nature of the business and superior investment fundamentals. You can understand why it’s something we have been attracted to for some time.
Last week we asked whether Thorn Group’s (TGA) recent outperformance was sustainable. The reason to ask is because it’s not the results of the past that will deliver returns to new shareholders, but whether the future matches that which is currently estimated.
To some extent, this question was answered for ARB by its management at the start of May – “The Board expects sales for the full year to be up by about 4% and for profit after tax to be in line with the previous year.”
While it is a slightly disappointing development – the market was expecting more – we think that any growth sans acquisitions in the current economic climate is not something to sneeze at. The business has faced challenging conditions this year following the Japanese earthquake, tsunami and Thailand floods, which together dramatically impacted the supply of new 4WDs. The key risk ahead is what proportion of their sales is impacted by declining iron ore prices feeding into a lower level of capex by mining companies.
Conversely, there is pent-up demand from a lack of vehicles being available for sale in the first half. May car sales data continued to show a strong rebound and indeed a record 38,000 new 4WDs sold out of a total 96,000 in total new cars in Australia. A record and, of course, ARB’s most important business segment.
Add to this the associated pent-up demand of accessories to fit out these new vehicles and what ARB is faced with is a current order book heading into the last three months of the financial year where demand is outstripping supply. An enviable position to be in.
Coupled with a highly capable management team who have not only controlled the businesses operating expenses at a time where sales and revenues were severely impacted, but have also used their conservatively managed and high quality balance sheet to continue expanding their production and distribution capacity to support future growth plans, we think the business has not hit its straps. And remember there are less than 50 stores worldwide.
Until our view changes, which is currently unlikely, this remains to us a business that is already succeeding in expanding overseas, a business that we will happily hold and a business for whom any share price weakness (provided intrinsic value’s remain unchanged) is a signal to accumulate more.
A broker sent us a copy of these notes taken at the 2012 Berkshire Annual general meeting. The media has taken excerpts and they’ve gone viral but we like the completeness of the document we were sent. Have a read and feel free to share your thoughts.
The 15th of April will mark the 100-year anniversary of the tragic sinking of the Titanic on its maiden voyage from Southampton England to New York. Owned by The Oceanic Steam Navigation Company or White Star Line of Boston Packets, the tragedy was not that her advanced safety features, which included watertight compartments and remotely activated watertight doors malfunctioned. The tragedy was the operational failure and that the Titanic lacked enough lifeboats to accommodate any more than a third of her total passenger and crew capacity.
It occurred to me on this anniversary that there are many lumbering, giant business boats listed on the Australian stock exchange today, whose journeys have been equally eventful, if not fatal, and whose management is no less responsible for operational failures and for providing lifeboats only for themselves.
Take the situation over at Leighton (ASX: LEI) – a company I wrote about here some time ago, saying: “There is a significant risk of downward revisions to current forecasts for the 2012 profit.” On March 30, the company wrote a further $254 million off its two biggest projects – Airport Link and the Victorian desalination plant. More broadly, Leighton downgraded its FY12 profit guidance to $400 million-$450 million from $600 million-$650 million, taking the company’s writedown tally to almost $2 billion in the past two years. This will reduce the return on equity from 22% to 15% for 2012, and significantly reduce the 2012 intrinsic value, which now sits below $14.00 (see graph below).
Back when I wrote my prediction, I also noted that workers at the desalination plant had cited ‘safety concerns’ causing them to work more cautiously (read slowly) to ensure their physical safety and the safety of their $200,000 per year wage, which of course would not continue beyond the project’s completion.
This week, it was revealed that similar problems have emerged at Brisbane’s Airport Link project. According to one report, “an increasing level of aggressive behaviour” from unionised workers who wanted to “get paid for longer” was an attempt to “leverage this finishing phase” of the project.
Leighton must construct to a deadline, and liquidated damages clauses cost the company about $1.1 million per day for every day that the Airport Link project is delayed. My guess is that as a result of the workforce’s alleged ‘go slow’, Leighton is forced to bring in hundreds of sub-contractors such as sparkies (with “specialist commissioning skills and experience”, according to John Holland) to complete the work. Either way, it costs Leighton more. A 25% blow-out on a multi-billion dollar project can amount to $1 billion.
On top of these problems, Leighton has a $200 million deferred equity commitment to make two years after Airport Link opens. And if my speculation that the operator may be broke before Christmas comes to fruition, Leighton will be forced to write off another $63 million – the amount remaining to be written down.
But before you jump to attack the unions reported to be responsible for Leighton’s woes – something I believe is often justified, not because of what the unions represent, which is honourable, but because of the tactics they sometimes use to seek redress – you should remember that there are many companies whose more humble management works in harmony with its workforces, unionised or otherwise.
Management is an important part of the investment analysis mix and while I firmly believe, as Buffett does, that the business boat you get into is far more important than the man doing the rowing, I do also believe that management will make the bed that ultimately every stakeholder must lie in.
Any company whose management drives flash cars to the office, pays herculean salaries to themselves and/or takes advantage of company relationships for self-gain is always going to be the target of unrest and distrust from its staff. This is driven often by envy, a sense of unfairness or lack of equity, and while I am not saying this is the case at Leighton, clearly there’s something amiss that is the root cause of this much trouble.
Over the last decade, Leighton has generated cash flow from operations of $8.3 billion, but its capital expenditure has now exceeded $7.5 billion. This would leave $800 million for dividends, but the company has paid dividends of over $2 billion (perhaps to appease non-unionised, income-seeking shareholders who support the share price upon which management’s lucrative remuneration is based). Given the cash to fund this dividend largesse was not generated by business operations, $850 million of ownership-diluting equity has been raised and $1.3 billion of debt borrowed. And for this less-than-spectacular performance, the top 10 current executives were paid almost $20 million last year. Eight of those were paid more than $1.2 million in 2011, four were paid more than $2.3 million, and the year before, three of the 10 were paid more than $4.5 million each.
Forecast profits for 2012 will not be any higher than five years ago, and the company workforce has doubled to 51,281 employees at June 30, 2011. But $190 million in salaries for 15 senior executives (excluding van der Laan’s $47,000) between 2007 and 2011 (see table), while overseeing such performance does not sit well with staff (or vocal but ineffectual minority shareholders) and it’s the relationship between management and staff that is more than partly to blame for the company’s ills.
Whether or not the CFMEU’s Dave Noonan’s claim in The Australian Financial Review this week is correct – specifically that “the markets were the last to know [about Airport Link], everybody else in the industry knew that the company were going to drop hundreds of millions of dollars and obviously they chose to tell the stock market very late in the piece” – is less significant than whether a carcinogenic tumour has grown between management and staff. The former can be resolved but the latter is potentially more permanent, and therefore damaging to shareholder returns.
Leighton is a fixture in the portfolios of thousands of superannuants nearing retirement and their disappointment with their investment returns can be at least partly attributed to the poor wealth-creating contribution of this company and its management. In turn, this can be attributed to the motivation and satisfaction of staff.
Shareholders are also the owners and have a right to know how management is performing, but now the majority shareholder’s demands will hold sway and the majority shareholder is Spain’s Grupo ACS, not the many Australian super funds who thought the company’s management was working for them. Oh, and I am guessing there is the risk of further writedowns on projects that haven’t yet hit the headlines.
Like the Titanic, where only the executives at White Star Line were truly safe, minority shareholders may find there aren’t enough lifeboats for them either.
Many of us grew up with a diet of the brilliant work of Walt Disney. As children we laughed and cried along with the characters of Donald Duck and Mickey Mouse, Cinderella and Bambi. More recently, boosted by the purchase of Steve’s Job’s Pixar business, Disney continues to build its library and draw many more generations into the fold with the characters of Finding Nemo, Toy Story, Monsters Inc and Cars. The company dominates with its ‘share-of-mind’ competitive advantage. In this Guest Post Andrew takes the scalpel to the company and dissects its major components.
What does your company REALLY do?
A nuts and bolts look inside the happiest company on earth
The ability to make assumptions about the future prospects of a business is fundamentally linked to how we understand that business. Without a good understanding you will be more than likely flying blind and your perceptions and reality could be in very different places and therefore throwing a great deal of uncertainty into any estimate of intrinsic value (which is linked more to the future prospects than anything).
A company that I am very fond of and one that I am sure almost everyone here has heard of is the Walt Disney Company (NYSE:DIS). I thought this would make a great case study in understanding the business.
So what does Walt Disney do? The first thing that comes to mind is the feature cartoons that it made its name on and its theme parks. These are the most iconic images that are attached to this famous company and more than likely where we were first knowingly exposed to the brand whether it be entering Disneyland for the first time and looking up Main Street towards the castle or watching movies like Snow White, Dumbo, Pinocchio.
What may surprise some people however is that most of the revenue and net income for the company comes from television.
Take a look at the below table:
Figure 1-Yearly breakdown of DIS segment revenue and net income (net income is before non-controlling interests taken out and are reported in US$ Millions)
As you can see in Fig.1, every year from 2001 to 2011, the largest contributor to revenue and profit (except 2002) was the Media Networks segment of the business. Over this period the company has on average brought in around 41.5% of the groups revenue and 55% of the net income as shown by fig 2.
Figure 2- Average % of total group figures
This technique of looking at the individual segment results and comparing them to the overall group is a technique I like to use to really understand the nuts and bolts of the business. Looking at these figures I can see that even though DIS made its name by animating feature cartoons and opening gigantic theme parks, it is the TV channels they own that make up the most crucial element of the business as it is today. There for if you were interested in investing in DIS you would be very wise to focus particular attention on understanding how the media Networks business derives its revenue and what risks are associated with this segment. Luckily the DIS annual report defines this in quite good detail but back to this later. One thing to realise though is that this type of analysis is greatly influenced by scale of operations. The biggest divisions will or at least should, bring in the bulk of the revenue and profits. It may be helpful to see on a relative basis at where the magic happens.
To do this, you might like to use profit margins of each segment. It is not uncommon for a diversified businesses smallest division to have the highest profit margin as in Qantas with their frequent flyer division. Disney is no different. It can change from year to year as shown in figure 3 however. Once again as you can see, lately it has been about the media networks. Looking at this however, you can gain a clearer picture of the profitability of each division in a relative manner. Despite being one of the smallest divisions, the consumer products segment is right up there in regards to profitability.
Figure 3- Net margins by division and overall group
So now, simply by looking at the financials we can get a clearer picture as to what DIS is really all about. We can see that the media networks business is arguably the most important. I can also see that the parks and resorts division is a pretty predictable segment with revenue and profit growth pretty consistent throughout the years and whose margins remain quite stable.
So where to next? Well you want to understand the risks associated with each segment so that you can be better placed to understand them and be able to make informed decisions and assumptions on the future. As mentioned earlier, the DIS annual Report actually goes into detail about the specific risks of each segment as well as detail as to how they derive their revenue. All annual reports will have a description of what the principal activities of the business are as well and if the management is shareholder orientated than it may include some very handy bits of information about the companies past, present and future. This is the next step, read all the information you can about that company whether it be through annual reports or newspaper articles, also read about the industry and read industry specific media to see what the insiders are doing and saying about the future. Knowledge is indeed power.
These are the simple steps to understanding a business and is aimed at the beginning investor although I think everyone can benefit from thinking more about how to understand a business they want to invest in.
Have you got any examples of businesses where the core operation may differ from what people may perceive? What gems can be found in the nuts and bolts of existing businesses? What techniques do you use to understand a new business? Feel free to post any thoughts below.
What do I think of Disney? Their return on equity has been increasing but is still below my required return so my valuation would still be at around or lower than their reported book value but I would love to own them personally. They are one of the biggest brands in the world and when they get it right, they create products that will last generations.