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.
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What is the value of a company that wakes up to find it has sold very little or even nothing in the last six months? My very long-term outlook for the price of oil hasn’t changed, but I can make the argument that the shares of Matrix C&E cannot currently be valued as a going concern any more confidently than I can a speculative exploration company.
While its a very harsh interpretation and its not the only interpretation, there are things to be concerned about.
Before I go into what disappointed me about the result, let me make an observation about the short term share price action. It appears that many short term investors could be overreacting to the report. Management are very confident that they will win new business and if they do, the share price represents and opportunity.
First, cash flow. Its something I have mentioned here at the blog previously – as have others.
Submitted on 2011/07/05 at 1:08am: “The short and mid term outlook for Matrix will be dependent on them securing some contracts and their cash flow will be dependent on them getting a few deposits paid. We have put a call into the company to see if we can get an answer but they may soon be in blackout so we’ll have to wait and see.”
Submitted on 2011/06/24 at 1:46pm: “Great stuff Ash. Good to challenge and shake things up. Any opposing views, go right ahead and put them up. I know that lots of you are concerned about Matrix. Watch their cash flows…”
There were many useful insights provided here at the blog about Matrix and their cash flow.
Prior to those comments, in April in fact, I noted we had participated in the capital raising at $8.50. But our holdings were small and hadn’t exceeded 1% of our portfolio because of our concerns about cash flow. You may also remember I demonstrated declining intrinsic values for Matrix in the future, which triggered some concerned responses. You really do need to understand the business, and the benefits of diversification.
Many might throw their hands up and give up on the intrinsic value approach, and while I would be delighted to see fewer value investors, this is as much an overreaction as the plunging share price may be today. There are critics who suggest there’s a problem with the intrinsic value approach. Gloating is predictable, but they do fail to understand that any shortcoming is not the approach but its application; You need to understand cash flow (heck, there’s a whole chapter in Value.able!) and you need to understand the business (it’s what Value.able is all about).
So here are some of the facts, thoughts and reasons I think the market is reacting the way it is. Don’t forget, in the short run, the market is a voting machine.
First:
MCE missed analysts’ expectations. Thats the first reason for a negative reaction by the market. I should point out that the share price has been declining significantly for two trading sessions prior to this blog post and has fallen 50% from its highs in April.
Second:
Profit grew 85 per cent (but not by as much on a per share basis). While the question should be if an analyst’s forecast is missed, is it the company’s fault or the analyst’s, in this case those forecasts are a function of company guidance. Guidance was $40 million at the start of the year, then $36 million. This week profit came in at $33.6 million. Earnings per share grew 56 per cent (less than the 85% growth in total NPAT) thanks to a capital raising that was used to construct a facility that hasn’t yet generated returns.
Third:
Fifty six percent growth in earnings is stunning. Make no mistake about that. Again, all things being equal, if such growth were to continue it would almost certainly cause intrinsic values to rise and materially.
Fourth:
The company is forecasting revenue growth of 20 per cent. This is “company guidance”. If NPAT margins can be maintained – duplication costs could be removed next year, which would be positive for margins – profit will equate to 52 cps. But in the face of few or no new contract wins in the last 12 months, are management being optimistic? Thats probably the key to working out if the current price is an overreaction and therefore an opportunity.
To grow revenue by 20 per cent to $224m, they need $114m of new work, on top of the current order book of $110m, which declined 70m in the last six months. Note the zero balance under Deposits in the Balance Sheet too. There’s $500 million of work in the tender pipeline. If they win 30% of that (a figure the company suggests is reasonable) that is $150 million and if won this year, will help the company achieve its target.
Fifth:
Analysts were forecasting 2012 EPS of 66 cents in July. Using these numbers, MCE’s valuation is over $10.00. But your valuation is only as good as your inputs. Those analysts are now forecasting earnings of 61 cents per share for 2012 and my own number is now closer to 51 cents (see above). In the absence of any announcements of contract wins, expect further downgrades from analysts.
Sixth:
Significant contract wins would have the opposite impact on intrinsic value and it could rise again.
Seventh:
If they achieve 52 cents of earnings per share, my intrinsic value becomes $6.80 – still significantly higher than the current share price but well down on the previous estimates of intrinsic value. The fact that $6.80 is above the current share price is one of the reasons I am keen to talk to the company!
But don’t forget, they have to win some contracts, because at the moment the [declining] order book is just 58 per cent of last year’s revenue. More importantly, in the absence of any contract wins, that intrinsic value could fall precipitously. As I say above; “There’s $500 million of work in the tender pipeline. If they win 30% of that (a figure the company suggests is reasonable) that is $150 million and if won this year, will help the company achieve its target.” Its important the company make clear (at the AGM for example) details about the length of the tendering and commissioning cycle for all shareholders.
Eighth:
Aaron Begley is confident that they will convert about 30% of the work they tender for. With $500 million in tender work thats will satisfy their revenue growth targets.
Ninth:
In the first half of last year cash declined, despite the fact the company borrowed more money and raised more capital. In the second half, the business generated just $900,000 of cash. There is no way to dress this up though and its not impressive for a company with a market cap earlier in the year of over $700 million and $350 million now. As mentioned in some of the posts, it could merely be a function of the long lead cycles of commissioning oil rigs, in which case there may be an opportunity worth investigating.
Tenth:
In conclusion, the results revealed this: Order book fell from $180m in the first half to $110m now. The $70 m decline is matched by the cash receipts in the second half. Given the fact that deposits in liabilities on the balance sheet fell to zero, we can assume the company made little or no new sales in the second half. Its with this in mind that you need to consider whether the companies forecasts are bullish or not. They need to win some business to justify the estimate of intrinsic value
As at June 30, 2011, MCE’s quality rating is A2. There is virtually zero chance of a liquidity event. But non manufacturing overheads are running at $750k a month, so the cash will be diminishing if there are no contract wins. That is what is driving the share price lower.
THEY NEED TO WIN SOME CONTRACTS OR SHAREHOLDERS NEED TO BETTER UNDERSTAND THE TENDERING CYCLE LENGTH.
Finally:
It is quite fair for critics to point out the one-eyed focus many investors have on the Value.able intrinsic value formula. The formula is a good one, but it is only as good as the inputs you feed it and they must come from an understanding of the business. I took a call from an share market investor who didn’t understand why the share price for Matrix was falling after reporting such strong profit growth. If that sounds like you, take a break and get back to the books to understand the business and its prospects. At the very least, it will help to either, 1) temper your enthusiasm for a company that is at a discount to your intrinsic value estimate, 2) change your estimate of intrinsic value or, 3) give you a better understanding of whether that intrinsic value is rising or declining.
On a separate note, there is a very real chance of a downside overreaction too, something we are always on the lookout for!
General and Educational Information only. Not a solicitation to act or trade in any security in any way. Always seek and take personal professional advice.
BigAir Group?
Digging in a little deeper to BigAir’s financials and you may notice a few things to be cautious about too – always important to read past what management tell you about revenue numbers climbing to the moon and do your own thinking.
These are all symptoms of a fast growing business, and a business which has grown by acquisition.
Firstly, a little cash strapped? Current Liabilities > Current Assets by 400k. This is mainly due to the $3.6m they owe on their acquisitions in the next 12 months. They have announced the acquisitions but hadn’t paid for them at June 30. Don’t forget that they also owe $1.375m, which is in non-current liabilities – a total of $5m in payments are still to be made for past acquisitions already announced. See note 18 to the accounts for more.
The next 12 months are important, and with Current Liabilities > Current Assets, its not an not an ideal position to be in, although they may be able to cover this by working their working capital. What you now need to work out is if future cash flow and of course CAPEX, which seems to run @ $2.5-$3.2m, will provide enough free cash for them to self fund their operations and liabilities. It is of course is hard to work out because maintenance CAPEX and growth CAPEX is harder to separate when a company grows quickly through acquisitions.
The university business may prove distracting, but some serious players in the industry really like fixed wireless broadband.
General and Educational Information only. Not a solicitation to act or trade in any security in any way. Always seek and take personal professional advice.
Posted by Roger Montgomery and his A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 24 August 2011.
Roger Montgomery heads back to Matrix to find out what happened to the share price and, more importantly, where it’s going. Read Roger’s article at www.eurekareport.com.au.
Qantas has reported a $250 million profit just a week after announcing plans to lay off 1,000 workers. Roger Montgomery says the airline does have to change drastically to cover the soaring costs of new aircraft. Read the transcript.
In the height of reporting season, and following the announcement of the annual results from Matrix Composite & Engineering (ASX:MCE), Roger Montgomery shares his insights and Value.able expert opinion with Ross Greenwood. Listen to podcast.
When to sell Rule #1 is: No junk policy. In the second part of Roger’s selling mini-series, he identifies Rule #2: Expensive.
While market declines alone don’t prove merit in selling shares, the broad declines do suggest a disciplined approach to shares significantly above an estimate of intrinsic value is necessary. For me, if the businesses are also of a lower quality in terms of our A1-C5 ratings, for example Asciano, Amcor, Westfield or Santos – there is an additional urgency to review.
Three weeks ago these C-rated businesses were all trading at prices significantly higher than an estimate of intrinsic value. Fast-forward to today (19 August 2011) and despite the falls, Safety Margins are are stubbornly high:
Asciano: -75 per cent
Amcor: -39 per cent
Westifeld: -46 per cent
Santos: -76 per cent
For us, it is neither here nor there whether you agree with our valuations and therefore Safety Margins. What is important for us and the portfolio we manage, is the combination of quality and value. In the absence of either trait, we would be unlikely to remain a holder of the shares.
It can be potentially permanent devastating holding shares in poor quality businesses at prices significantly above value.
Imagine you acquired shares in a business today for $2 and estimated those shares to be worth $4, rising to $4.10 the following year. Then suppose after six months the share price rises to $3.00. What would you do? Value.able Graduates, are expected to answer that question correctly. Now imagine the price of those same shares has risen to $6 in the same time frame. Would your answer change?
It may be tempting to set up some hard and fast rules about when to sell. I am not as comfortable with this approach as I am with the idea that the appropriate premium above intrinsic value at which to sell depends on the future prospect for the company and therefore its intrinsic value for the future.
Your response may be that there is greater uncertainty in future valuations. If that is your view, then you should sell.
Whilst we should not try to predict the future, it is important to look through a conservative telescope. What will be the value of each company in your portfolio next year? And the following year? Understanding the business and using that understanding to help establish prospects for intrinsic value appreciation in the future is a vital component of the Value.able approach, we advocate here.
If you are yet to join the Graduate Class, order your copy of Value.able immediately at http://www.rogermontgomery.com/. Once you have 1. read Value.able and 2. changed some part of the way you think about the stock market, my team and I will be delighted to officially welcome you as a Graduate of the Class of 2011 (and invite you to become a founding member of our soon-to-be-released next-generation A1 service).
Value.able TV #5 was recorded at Montgomery HQ on 19 August 2011.
Posted by Roger Montgomery’s A1 team, fund managers and creators of the next-generation A1 service for stock market investors, 19 August 2011.
Visit http://www.rogermontgomery.com/ for Roger Montgomery’s step-by-step guide to valuing the best stocks and buying them for less than they’re worth.
Qantas is planning to drastically cut costs by forming two new airlines and cutting 1,000 jobs in Australia. Roger Montgomery reveals his thoughts on Qantas. Read the transcript.
Congratulations are in order at our office.
Not to Forge or ARB for their full year results released today but to Chris B. our resident Albert Einstein, data integrity guru and valuation formula genius. Chris became a CFA today.
Well done Chris.
Thanks for all your hard work and keep it up – its working! Just look at the chart.
We are all excited to have you on the team.
(note: Yes everyone the results ARE due to significant amounts of cash (inflows) that the process Chris helped developed DID NOT deploy into the market) Well done Chris and on behalf of our investors thank you.
Posted by Roger Montgomery, 17 August 2011, with sincere thanks.
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An Information Memorandum (“Offer Document”) for the Fund(s) is available from Montgomery. Potential investors should consider the Offer Document in deciding whether to acquire, or to continue to hold, units in the Fund(s). Montgomery, its officers, employees and agents believe that the information is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors or omissions (including responsibility to any person by reason of negligence) is accepted by Montgomery, its officers, employees or agents. This online blog contains general information only and is not intended to represent general or specific investment or professional advice. The information does not take into account an individual’s financial circumstances. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial or other professional adviser before making an investment decision. No guarantee as to the capital value of investments in the Fund(s) nor future returns is made by Montgomery.
In this appearance on Your Money Your Call, Roger Montgomery answers viewer questions on McMillan Shakespeare (ASX:MMS), Ansell (ASX:ANN) Think Smart (ASX:TSM), Thorn Group (ASX:TGA), GR Engineering (ASX:GNG) and Technology One (ASX:TNE). Roger also reveals which gold stock continues to attract his Value.able eye? Watch the interview.
Your teenager wants to invest in the stock market. They have $6000 sitting in an ‘advantage saver’. What should they do? Roger Montgomery suggests this young investor seek out businesses with high rates of return on equity, little or no debt and bright prospects. The final step is to ensure shares in such businesses are acquired at prices less than they’re worth. In this interview Roger also shares his suggested portfolio allocation strategy to minimise risk for this young investor and reveals why he was pleased by Credit Corps (ASX:CCP) full-year results. Watch the interview.
In this appearance on Your Money Your Call, Roger Montgomery reveals nine extraordinary businesses he recently acquired for The Montgomery [Private] Fund. Roger urges investors not to be fearful of market downturns, but rather embrace the opportunity to acquire extraordinary A1 businesses for prices less than they’re worth. Roger also answers viewers’ questions on Forge (ASX:FGE), Macmahon Holdings (ASX:MAH) and Decmil (ASX:DCG) – whose intrinsic value is forecast to rise to above $8 by 2013? Watch the interview.
