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Are you being served?

Are you being served?

PORTFOLIO POINT: Office provider Servcorp is basking in strong earnings forecasts from analysts, but a capital raising in 2010 raises some important questions about the company.

Recently (Click here), I discussed Leighton and the quality of management’s relationship with its employees. Here I look at another company with a shareholder who holds a controlling stake, and examine its relationship with minority shareholders.

You can look at anything from a number of angles and, more often than not, reach an entirely different conclusion. Two investors, for example, presented with the same set of facts can reach polar opposite conclusions. It’s the old glass half-full versus half-empty line.

I find that having a set view and unwittingly being tied to that perspective limits one’s ability to switch fast enough when the evidence is mounting that the view might be wrong. Few are completely immune, but self-awareness is the first step to conquering any weaknesses.

The investing consequence of opening one’s mind to change is that portfolio turnover goes up. I may buy something back that I recently sold, because new evidence suggests I should, and that ‘re-purchase’ may be at a higher price. This may be seen as somewhat flaky and I agree it would be, if it were not evidence-based.

Looking at things differently, however, is necessary because it does produce fresh insights. On page 20 of Warren Buffett’s 2003 annual letter to shareholders, he wrote: “…I made a big mistake in not selling several of our larger holdings during The Great Bubble.” Shining a light – or perhaps a light with a different filter – undeniably helps our investment analysis.

With that in mind, I want to present some numbers from Servcorp’s annual reports and ask you to think about what your conclusion might be.

This service and virtual office provider has not produced growing profits since 2007.

Source:  www.Skaffold.com PATENTS PENDING.

Back then, profits were $34 million, and while they grew to $39 million in 2009, they subsequently fell to $5 million in 2010 and $4 million in 2011. For the record, analysts are in aggregate forecasting profits to grow to $13 million in 2012, and $28 million and $37 million in 2013 and 2014, respectively.

So that’s one way of looking at this business and on that basis, you may be tempted to investigate the opportunity as a turnaround story. I certainly am, as any global recovery from the Euro crisis would position Servcorp well with the rollout of its floor leasing operations.

Is there another perspective?

But before I go jumping in, here’s another way to consider the information. In 2010, the full year profits plunged to $5 million, the company raised $78 million – on top of the $76 million already invested – by issuing 18 million shares. This move took shares on issue to 98 million and capital raised to $154 million. And looking at the retained earnings account for that year reveals that the balance declined by $10 million.  This is something I want to pick up on.

When a company earns a profit of $5 million, as Servcorp did in 2010, retained earnings rise by this amount. Then, if dividends are paid, retained earnings goes down by the amount of the dividend. A net decline of $10 million in retained earnings after a $5 million profit suggests $15 million was paid in dividends.

One way to look at this situation is to assume that the capital raising is for growth; I will give the company the benefit of the doubt and agree. An alternative and admittedly more cynical way to look at it is to assume the capital raising might have been designed to pay for the dividend.

One response to the latter proposition and the one I am leaning towards is that the capital raising was much larger than the amount the dividend exceeded earnings by and therefore the real intention of the capital raising was, indeed, growth. In turn, one retort from a much more jaded or cynical investor could be that the capital raising was made larger to disguise the fact that a larger dividend was desired. It’s all rather circular, as you will discover in a moment.

Perhaps we might never know the thought process of the board at the time and such postulations are only speculative at best, but there are two important questions, answers to which would provide some illumination. The first would be whether the money invested does indeed lead to the growth in earnings that the analysts seem to be expecting – albeit growth that will only produce profits in 2014 that are in line with those of 2007/08. The second might be to ask whether a majority and controlling shareholder is present. Once again, we can’t prove motives, but as investors we are certainly within our rights to enquire.

In the first instance, only time will tell us whether the money is invested profitably. The cash is certainly now available to help grow the business, revenue and profits. To the credit of management, first-half 2012 profits were over $8 million. So the numbers are indeed moving in the right direction.

Regarding the latter issue of ownership, we find the managing director and CEO also owns 51% of the company. Of course, to retain control they must have participated in the capital raising during the 2010 financial year, but keep in mind it could be argued that half the dividend helped fund it.

And I always ask the following question: If a company is in need of capital, why pay a dividend? It’s a basic question and often – but not always – the answer seems to point to maintaining support for the share price, a noble (if perhaps unsustainable and diluting) goal. Directors are arguably acting in shareholder’s best interests by doing things that support the share price but it is imperative the techniques are sustainable. Ultimately the best method is a sound business.

In 2011, the company did almost the same thing as it did in 2010. While no additional equity was raised, and thus the controlling shareholder was therefore spared the requirement of writing another cheque, profits of $4 million were reported, but dividends of $16 million (51% of which went to entities associated with the CEO/MD) ensured that retained earnings fell to $59 million. The $8 million dollars (50% of the dividend) arguably further reduced the personal contribution of the majority shareholder to the capital raising.

For our fund, a return on equity now of just 7% suggests Servcorp is currently not investment grade, and its share price also appears to be expensive compared to our estimate of its intrinsic value. That would change if upgrades to guidance are provided.

While we haven’t answered the questions we posed, we have certainly raised the one we should ask management before we decide to invest. In theory the board works for the shareholders so you are within your rights to ask questions such as these of the board. For your own investing, I can only leave it to you to decide whether the cup is half-full or half-empty.

Posted by Roger Montgomery, Value.able author, SkaffoldChairman and Fund Manager, 3 May 2012.


Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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  1. As at 30 June 2009, SRV had about $84m in cash. Its free cashflow was $36m. That is more than adequate to fund dividends of about $18m. A few months later, it did the capital raising.

    Now, SRV has over $100m in cash, with leases entered into at cheap GFC rates, all using the strong AUD.

    In over 10 years of conduct, I can find at least two instances where management chose to act in shareholder’s interest as a whole, when they clearly had the opportunity to enrich themselves.

    You appear to be torturing facts to fit the hypothesis.

    • Hi Peter,

      Thank you for your note. Your comments are the reason I wrote: ” …An alternative and admittedly more cynical way to look at it…” It is indeed a more cynical view. The cynical view is not my view. The interesting question to ask is, why raise the cash? And of course I am delighted to publish your thoughts here and if you would like to provide the two or more examples of management acting in shareholders interests over the last decade. Indeed I would be equally delighted to republish them under the heading of “Servecorp’s good corporate citizenry”. I await your contribution.

      • Thank you for your invitation for further contribution.

        I sincerely see no further need to publish information which could easily be uncovered by research.

        I do take the point that it is questionable (and wasteful) capital allocation to raise capital and pay a dividend at the same time. I do seem to recall that they declared the dividend first, and then 2 months later, decided to raise capital.

  2. Hi Roger .. as I continue my journey of learning the nuts and bolts of what makes a “value” business to invest in from studying Skaffold I wonder if you could help me by explaining the rating of WES as an A2 stock yet it is trading at about double its intrinsic value with a safety margin of -51% ….. most of the other “market measures” seem to indicate it is a healthy company with an increasing % of return on equity. Why is it so far ahead of its intrinsic value?

    • Hi John,

      What is the company’s return on equity? It is less than 9% for 2012 and less than 10% for 2013. If you seek a return that is less than than that, you can pay a premium for each dollar of equity. if however you seek a return that is higher than the return being generated by the equity, the only rational price to pay is a discount to that equity per share. The company has added no intrinsic value for a decade and unsurprisingly, the price is at the same level as where it was in October 2004. It is so far ahead of its value because 1) the point of the valuation is to help find bargains rather than ‘explain’ the current price and 2) the value is based on sound reasoning while 3) the price is based on popularity and the fact large insto’s are bereft of a sufficient number of high quality companies in which to invest and so they have to buy ‘big’ rather than ‘great’.

  3. Hi Roger,

    I wanted to ask for some insight on a speculative CSG play that I have a holding in called Blue Energy (BUL). It hasn’t done much in the way of growing its reserve base and is a long way off its projections at present. It also recently conducted a capital raising via an SPP. They have recently appointed former Santos CEO John Ellice-Flint to the board. He is obviously very well credentialed to assist the company in meeting its objectives, however his performance rights and fee to sign on left many suprised.

    Whats your take on their “story” is it just that, or do you think they could turn the corner?

  4. Gurkamal Kanwar

    Hi Roger
    Very interesting article. You provide wealth of finance and investment knowledge. Keep it up.



  5. In the Servcorp story I see shades of Kerry Stokes’ running of his interests in Seven Group Holdings. The transfer of a big slab of debt to Seven West Media, in which Seven group has a less than 30% interest, would I thought have set red lights flashing in the minds of Seven West Media shareholders long before the recent downgrade and dramatic price fall of Media shares. Could it be that major shareholders will move whatever mountains are necessary to serve their own best interests?

    Here’s where it gets interesting for me though. I sincerely hope no-one has been hit by a big loss on JBH, but for me, the writing was on the wall when the richly applauded former chief of JBH, Richard Uechtritz, left to join the board of Seven Group and began buying up blocks of Seven group shares at $6 and $7.50. The price falls of JBH and the rise of Seven Group (SVW) have mirrored those facts.

    Some time ago I read a Eureka Report article about watching the movements in and out of shares by Australia’s A list of rich directors. I remember writing in and asking for some comment about Stokes, whose name at the time was not even mentioned.
    No-one seemed interested. I offer all this purely as an observation
    that I think there is much to be divined from director’s major moves that is otherwise hard to discern. ( I do not hold Seven group equity, though I do hold some SVWPA, its hybrid.)

    Are there investors here in Rogerland in either of the Seven companies? What are your thoughts?

    • Hi David,

      I wrote about that very topic. Will post something in the next day or two for you to read but yes, I am also interested in whether anyone has participated in the rally of seven.

  6. Competitive advantage? Barriers to entry? Competent and able management? A leading supplier in terms of reputation for its service and products?

    “For the record, analysts are in aggregate forecasting profits to grow to $13 million in 2012, and $28 million and $37 million in 2013 and 2014, respectively.”

    Experience would indicate to me that they’re having a laugh Roger.

  7. Hi Roger,
    Great little summary about how to get the most out of the Capital History screen. If I were hip and trendy in facebook I would “like it”.

    On a side note, are you the one selling out of SLR at the moment I am considering getting in? That would be just my luck. Big move down yesterday on no news.

    • The qrtly report on Monday 30th indicated a drop in grade and a drop in gold sold, which probably spooked the market over the following days.
      However if you look at the detail, this is explained by the fact that over the last qtr they were mining lower grade ore in order to later access higher grade ore of the main deposit.
      Miners always have to balance between development costs and production costs, development is a requirement to reach producing areas. Also there are choices between producing from high grade zones or lower grade zones. The shonky miners have often produced from high grade zones when gold prices were high (a process called high grading), it was a lazy way to make profit, but they came to grief when prices dropped and they only had low grade ore left.
      SLR’s decision has been deliberate and prudent but will lead to better long term profits.
      They are excellent managers and are expanding their reserves, leading to long term profit.
      I’m impressed by the detail of their quarterly reports, it keeps you up to date with whats happening.
      Roger has taught us to seek quality companies, and pounce if there is a price dip.
      I think SLR is a quality company and this is the sort of price dip we wait for, hence an excellent entry point in my opinion.

      • Nice points you raise there Nigel with the production decisions. I also saw the drop in gold sold, but have my eyes on the management targets which are still in place for a couple of years time.

        Of course another factor may be that the gold price bears are gaining ascendancy in the market. Many gold miners have been hit hard in the last week or two.

  8. It is a possible turn around situation but i am not particularly fond of those as there is an element of plopping your chips down on a number and hoping the roulette will comes up (sometimes however it might be more of black,red bet i’ll admit so the odds are a bit better but the metaphor still rings true i think)

    I really enjoyed the final bit Roger, it provided a great insight as to things to look out for. I don’t think it is cynical to think that a decrease in retained earnings at the same time a capital raising takes place could mean that the capital raising was to at least find the dividend.

    Thanks for this interesting post.

  9. Roger,

    Your writings are always thought provoking.

    I had a question – what do you understand by, “a bird in hand is worth 2 in the bush”. (This reference is also made by Gerald Loeb in, The Battle for Investment Survival).

    Is it simply Warren Buffett’s compounding formula?
    Or does it mean that we should look for certainty (moat) in returns?
    Some people compare this to rewards versus interest rates (depending on whether it is high or low).

    Perhaps you have the right understanding of this statement.
    Thanks. Your reply will be much appreciated.


      • You have hit the nail on the head !

        It sounded like the compounding formula for calculating the intrinsic value of retained earnings component.

        Though I am not sure what Mr Buffett meant by “you should know when the bird will come out” . He always claimed the “when” is the unknown variable. I guess he meant when the interest rates are low or something?

      • In a value.able type of way roger would I be correct in saying that the more birds in the bush that bird in the hand is worth over a peiod of time than the more that can be paid for that particular bird in the hand?

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