Monthly Archives: September 2013

Whilst we do not own the shares in the business and haven’t for some time, we previously commented on a number of headwinds we thought Blackmores was facing. Naturally we read their full year result with interest to see how things are progressing. Continue…

by Russell Muldoon Posted in Health Care, Insightful Insights, Value.able.

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In this month’s column for Money magazine, Roger talks about why investors should back companies that will last the distance. Read here.

by Roger Montgomery Posted in In the Press.

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Retail is a tricky sector for investors at the moment. But amidst the harsh conditions, there are some glimmers of opportunity. In this article, Roger Montgomery talks about where we are casting our gaze.

It takes nerves of steel to buy small fashion retailers in this market. Weak consumer confidence, sluggish retail sales growth, price discounting and the online sales threat are pounding the sector. But within the carnage are potential opportunities such as Speciality Fashion Group (SFH).

The turnaround play is in the eye of the retail storm. With 892 stores across the Millers, Katies, Crossroads, Autograph, City Chic and La Senza brands, and around 180 million interactions with Australian shoppers each year, SFH is incredibly leveraged to discretionary spending conditions.

Apparel is a tricky business at the best of times; fashion-fickle consumers and seasonal disruptions such as a warmer-than-expected winter can crunch sales. It takes great skill to sell more clothes when so many headwinds conspire to stop consumers spending.

The list of retail problems is long and growing. In the short term, interest-rate cuts are having less effect as consumers remain concerned about job security and prefer to pay down debt (or buy investment properties!) and spend less. Retail sales grew just 0.1 per cent in May, compared with market expectations of 0.3 per cent.

The lead-up to elections is rarely good for retailers and online sales continue to eat into traditional retail sales channels, albeit off a low base. Rampant price discounting has conditioned consumers to expect ever-lower prices for basic items such as cheap clothing, which the likes of K-Mart almost seem to give away.

These trends are taking a heavy toll. One of SFH’s nearest listed rivals, Noni-B, saw its share price tumble this year after reporting deteriorating conditions within and without.

Among large apparel sellers, Target has been a basket case. Parent company Wesfarmers issued a profit warning for its troubled discount store in May, blaming lower sales, shrinking profit margins, excess inventory and a late start to the winter season. Target’s woes put chills through the broader apparel sector as analysts feared higher-than- expected unsold inventory.

The apparel sector, it seems, can’t take a trick this year. The tragic factory collapse in Bangladesh this year, which killed more than 1,000 garment workers, has put the spotlight on Australian importers such as K-Mart, which source garments, directly or indirectly, from third-world countries.

But despite these problems, some, if not many, retail stocks have rallied in 2013. JB Hi-Fi, for example, has a one-year shareholder return of 105 per cent (including dividends) after touching a 52- week low of $8.34. Kathmandu Holdings is up 89 per cent over one year, and Myer Holdings is up 46 per cent.

These are remarkable performances in the context of such a weak retail market. They show how investors can badly misprice stocks when market noise peaks and everybody is focused on backward- looking newspaper headlines rather than looking forward. The market was too negative towards some high-quality retailers in late 2012, and investors, as is their wont, confused price and value.

This was true of SFH when its shares plumbed 47 cents in 2012 at the peak of the retail-gloom hysteria. Following a surprisingly strong interim profit report in February, the company soared to a 52-week high of $1.20 before retreating to a low of 78 cents in the past few months.

SFH was an easy stock to sell in 2012. As retail sales growth slowed, fewer women would buy dresses at its shops, or would seek lower- priced substitutes at the discount department stores, or so the theory went. And SFH has been a volatile, arguably lower-quality retailer at times over the past decade.

It posted a $2.8 million loss in FY12, partly from higher depreciation charges due to a store rationalisation program, did not declare a final dividend, and gave a cautious view of its outlook. But beneath the gloom were good signs of improving operational performance.

Supply-chain enhancements bolstered the company’s gross profit margin, more goods were being sold online, and operating cash flows were higher due to much better management of working capital. Simply put, SFH was rapidly improving the business to combat retail headwinds.

Those initiatives underpinned sharply improved performance in the first half of FY13. Revenue rose 1.3 per cent to $311.1 million on the same half year earlier, net profit soared from $6.1 million to $17.9 million, and basic earnings per share almost tripled to 9.3 cents.

A 62.4 per cent gross margin was the highest in the company’s history, up a whopping 477 basis points over the half. Higher selling prices, lower product and freight costs, and the benefits of investments in moving to a design and direct sourcing model are transforming SFH’s margins, with another 150 basis points in margin gains targeted for the second half of FY13.

Other cost controls also impressed. It limited cost increases to 1.2 per cent for the half despite annual wage inflation of 3 per cent. Lower base rentals on renewed store leases and the exit of underperforming stores helped contain cost increases.

Although it has done an excellent job in becoming more productive and efficient, those gains alone will not drive SFH sharply higher in the next 3-5 years. The company needs to better leverage its great,

under-recognised strength – a database of 7 million customers built over decades.

Notwithstanding the inevitable ‘returns to senders’ and ‘email address not recognised’, the power of this database, and SFH’s retail reach, usually gets scant consideration in analyst reports, even though it is the key to the company’s long-term fortunes. It is not well known that 55 per cent of Australia’s female adult population are on SFH databases, according to SFH figures.

Long-time market watchers will remember the work of Miller’s Retail Group, once a standalone ASX-listed company, in building a huge database of fashion devotees through a “club format” long before the internet made such channels a critical part of retailing.

SFH is doing a much better job mining this database and improving its customer communication and touchpoints. Its email-valid membership, now 2.5 million and rising, is a huge platform to provide targeted marketing offers to deal-hungry consumers.

A strong ‘omnichannel’ distribution platform – across physical stores and online – is critical in retailing these days, and a significant source of sustainable competitive advantage and value for SFH. The challenge now is to turn that database into sharply higher, sustained sales growth.

For all its recent achievements, SFH does not appear to have received the recognition it deserves. Although it has a volatile record, SFH is starting to look like a much more consistent, high- quality company that ticks key boxes for long-term value investors.

It had net cash of $38.6 million on the balance sheet at June 30, 2013 – down from $45.6 million on the balance sheet at December 31, 2012, which was the highest in seven years. The company repaid $6.5 million of debt in the first half, and has no outstanding debt. A 27.9 per cent Return on Equity (ROE) for FY13 also impressed, given the retail malaise.

SFH has plenty of cash for a circa $150-million company (probably too much) and firepower to make acquisitions as the troubled retail sector inevitably throws up opportunities. It has been touted as a takeover target for the fast-growing Cotton On Group, which has a 20 per cent stake and two directors on the SFH board. Cotton On emerged on the SFH register in 2010.

The key question, of course, is does value exist now?

Another interest-rate cut, a stabilisation of the Australian dollar, and the resolution of the Federal election could spur confidence and give cash registers a slightly stronger ring in the next 12 months, and also create more market focus on the retail sector.

But if conditions remain exceedingly tough, as seems likely, SFH has at least shown it has the right formula, management skill and balance sheet to weather the retail storm.

This article was written on 1 September 2013. All share and other prices and movements in prices are to this date.

by Roger Montgomery Posted in Consumer discretionary.

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As the share prices of many mining services companies performed as we have been warning they would, the question we receive from many investors is: is time to wade back in? In the context of Mermaid Marine, we address the question.

Value investors will need great skill to make money from the resource services sector. Pessimists point to $150 billion of mining and energy projects delayed, cancelled or reassessed in Australia in the past 12 months. Optimists argue that there is value aplenty in the sector after horrific share price falls.

The truth is somewhere in between. There is good reason to continuing avoiding the resource-services sector: the Bureau of Resources and Energy Economics (BREE) forecasts the worth of committed projects, or those likely to get to that stage in the next five years, will drop from $256 billion from the end of 2013 to about $70 billion in 2017.

It could get worse if falling commodity projects force a few mega projects to remain in publicly announced feasibility phases, meaning even less work for service providers. Boart Longyear’s terrible earnings result in August and talk that it could breach debt covenants reinforces the danger. Don’t be surprised if a few lower- quality mining services companies go under in the next year or two.

Resource services is not a great industry at the best of times: it is highly leveraged to projects that rely on volatile commodity prices, requires high fixed investment, suffers from rapidly depreciating equipment, and is a price taker. Shrinking profit margins are another huge risk this financial year.

But if all of that doesn’t dissuade you, the question is whether this deteriorating outlook is already priced into valuations. Monadelphous Group, for example, appears to be back in value territory, but it needs to offer a bigger margin of safety, such is

the uncertainty about resource projects. Forge Group and Decmil Group might also be considered similarly.

Then there are resource service providers rising in a falling sector. The well-run Clough group has doubled to $1.44 since late 2012 after earnings upgrades. Accommodation provider Titan Energy Service has soared fivefold in the past 12 months on the back of higher earnings, and Mermaid Marine Australia, which provides vessels for oil and gas projects, has rallied in the past year.

That shows the danger of being deafened by newspaper headlines and market noise about falling mining investments and extrapolating it to all stocks, rather than treating each company on its merits. Value investors should always focus on what matters most: buying exceptional companies at bargain prices. On this score, Mermaid Marine warrants a spot on watchlists.

A 10 per cent share fall would arguably put Mermaid within sight of value territory; and a cheaper entry point could emerge as the sharemarket moves into the traditionally weaker September and October months, and as nervousness about emerging markets and US Federal Reserve plans to ‘taper’ its stimulus program creates higher market volatility. Whatever happens, Mermaid might be worth watching.

Like Clough, Mermaid is heavily exposed to the energy sector. It provides marine logistics to offshore oil and gas projects and has supply bases in Dampier and Broome. The core operation comprises a fleet of more than 30 ships; the Dampier base has a private wharf and ship-repair facility; and the Broome supply operation is a 50/50 joint venture with Toll Holdings.

Choosing service providers with a bias towards higher-margin oil and gas projects rather than mineral developments is a smart move. Committed liquid natural gas and petroleum projects were worth more than $200 billion at April 2013, according to BREE. That dwarfs all other products (by commodity) and there are still several big energy projects in publicly announced feasibility stages.

The energy boom has been a huge tailwind for Mermaid. Over five years, the company has an average annual compound return (including dividend reinvestment) of 21 per cent. Over one year to August 30, it has returned 26 per cent – a good result in such a weak sector.

The latest profit result impressed, given cyclone-affected vessel utilisation rates in the third quarter. Revenue rose 18 per cent to $449.5 million and after-tax net profit lifted 18 per cent to $60.3 million for 2012-13. Earnings per share rose 15 per cent to

26.9 cents and a 12.5 cent full-year dividend was declared.

A flat result in the vessels division (63 per cent of revenue) was offset by strong results in the supply base and slipway (maintenance) divisions.

Another concern is the strength of Mermaid’s sustainable competitive advantage. Being the dominant vessel provider in Australia, and having an integrated offering of vessels, supply bases and maintenance gives it a significant competitive advantage over smaller rivals. It also has an excellent industry reputation.

However, this advantage is arguably hard to scale overseas and this is relevant given the company has signalled international expansion as a key strategic priority. Different union arrangements and regulatory regimes in other countries may limit growth, and currently only 2.9 per cent of Mermaid’s revenue comes from its offshore operations.

Mermaid is heavily exposed to a small number of energy projects in Australia that will start to wind down in the next few years. It still has solid, long-term earnings prospects, given these projects will require plenty of ongoing vessel and supply-base support, but growth could plateau.

Mermaid ticks plenty of boxes for value investors. Return on equity (ROE) has hovered around 17 per cent in the past seven financial years and peaked at 21 per cent in FY10. Although solid rather than spectacular, Mermaid’s ROE consistency is notable in a volatile sector.

Cash flow generated from operations has soared from $18.1 million in FY07 to $70.8 million in FY13. Gearing (net debt/equity) of 30 per cent at the end of FY13 was hardly excessive given Mermaid has invested more than $200 million in fleet renewal and infrastructure development programs over five years. And it has $58.8 million in the bank.

Mermaid said its medium-term outlook “remains strong”, with construction on mega energy projects such as Gorgon ($52 billion) continuing through FY14 and FY15, near-shore works underway for Wheatstone ($29 billion), and several other project tenders yet to be awarded or called for.

The company announced in August it had won a $100 million contract to provide tug and barge support for part of the Chevron- operated Gorgon project – an encouraging result given the risk of lower fleet-utilisation rates as construction activity at Gorgon trends lower in the next few years.

Earnings from supply bases, just over half of Mermaid’s FY13 earnings before interest and tax, look more vulnerable as energy construction slows in the next few years. This might explain why management is increasing the company’s exposure to production- support contacts and new project activity here and overseas.

Mermaid should have decent earnings momentum in FY14 and FY15, but the big question is: what happens when investment in giant energy projects tapers after that? Here at Montgomery, we don’t treat that question lightly: will Mermaid be left with a huge earnings void that is hard to replace? And when will the market price this in? New enterprise bargaining agreements and potential for rising industrial disputation are other threats.

According to its valuations, Montgomery expects Mermaid’s ROE to ease from 16 per cent in FY13 to 15 per cent over the next two years and 14 per cent in FY16, based on consensus analyst forecasts. Value investors should seek companies with rising, or at least stable, ROE, and at least above 15 per cent, for it usually leads to higher intrinsic value and ultimately a higher share price.

At $3.77, Mermaid remains overvalued. Value investors should look for companies that can deliver strong increases in intrinsic value in future years. Given the uncertainty surrounding 2015 and beyond, the jury remains out on the score for Mermaid.

Investors should also demand a higher margin of safety from resource-service stocks, given uncertainty about the project pipeline and rising earnings risks. Mermaid might need to trade closer to $3.00 to tempt long-term value investors.

Although not exceptional, Mermaid has been of high quality for a long time and after share price gains this year is only modestly overvalued.

This article was written on 1 Septemeber 2013. All share and other prices and movements in prices are to this date.

by Roger Montgomery Posted in Energy / Resources.

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