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What do I think of McMillan Shakespeare Now?

What do I think of McMillan Shakespeare Now?

It is not unusual for me to seem contrarian in my thoughts about stocks. And it is often the case that I am fond of companies out of favour at least temporarily. As prices rise I become less enthused rather than more so. Quite simply, the higher the price, the lower the return.

The last time I commented about McMillan Shakespeare was 27 May this year (MMS: $2.64). It was then that I stated that if that nothing came out of the Ken Henry Tax Review that permanently impacted MMS’ profitability, the shares were worth $6.01 – you can find me making those comments here.

With the benefit of hindsight, we now know that the legislative concerns surrounding the business failed to eventuate (well not yet – they await the next Government), and the shares have traded as high as $6.45 since.

But since MMS has released its annual results, you may be wondering if and how my thoughts have changed since May. Please keep in mind, as I have said many times before, I am under no obligation to continue analysing a business or updating my comments.

If you watch the interview above, clearly I was happy with the quality of MMS and its valuation being materially above its price. Indeed it was one of my A1’s at the time – so let me fill in the gaps.

As you would be well aware from Value.able, you should not focus on the share price but on the business itself. It’s a simple truth that if the underlying business does well then the share price tends to look after itself. While I am impressed about the price currently trading close to my valuation, am I still happy with MMS as an investment candidate? In short, no.

Things can change pretty quickly in business. One minute you are staring down the barrel of a major financial review with the threat of having half of your business taken away over night, and the next you are on the front foot and announcing a major acquisition. It’s the latter than concerns me.

Three days after my TV interview, MMS management announced the acquisition of Interleasing (Australia) Limited (ILA) in a 34 page information memorandum and 9 days later completed the purchase.

In that IM was a detailed breakdown of the purchase. I had suspected for a long time that management where keenly looking for an acquisition given it was producing so much free cash flow.

Up until this point, MMS had been an A1 every year since 2006. Given my stringent A1 rules, to achieve this rating four years in a row is an excellent achievement by founder Anthony Podesta. But with new management come new ideas, and this time the idea was to take a debt free business and fund the ILA acquisition with $25m of existing cash, $41.3m from the sale of ILA’s novated lease receivables and debt totalling $141.7m. A total purchase price (not value) of $208m.

The impact can be seen on the business’s balance sheet;

Source: MMS 2010 Annual Report

If you tally the circles labelled “1” you will discover that the business now has net debt (total debt less cash and bank balances) of $125.156m. If you then look at the final line of the balance sheet “equity” which stands at $89,417 we can calculate that MMS (which was completely debt free last year) now has a gearing level of 139.97%. This in anyone’s book is a high level of gearing and a material change on the conservative financials in prior years.

If we now look at the circles labelled ‘2”, you will note that the business’s current liabilities (items which generally require repayment within the next 12 months) exceed by more than double the level of current assets (the liquid assets available to meet obligations due within the next 12 months).

In analyst speak; a current ratio of just 0.4972 is generally poor. In contrast the ratio last year was a healthy 1.9694.

While the uplift in earnings per share has been a boon for shareholders, as you can see, there has been a huge price to pay. In summary, the quality of the business has fallen from what I considered to be an A1 business to a B3.

Many will argue that MMS generates huge cashflows and that it still produces excellent (albeit highly geared) returns on equity and it should therefore have no concerns in meeting its interest expenses and maintaining its current capital structure for the foreseeable future. While this is all true, I always prefer to reduce risk in my portfolio by owning extraordinary businesses.

My investment process prevents me from investing in anything but the highest quality companies; one of the characteristics that I look for is little or no debt.

Also, when management start saying “key requirements of this funding” are that our “dividend payout ratio not to exceed 65%”, “interest and debt cover covenants” I have to wonder; are management controlling the business or is the bank?

Posted by Roger Montgomery, 26 August 2010.

INVEST WITH MONTGOMERY

Roger 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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103 Comments

  1. Quite a lot of water has passed under the bridge since your last posts. Any chance of an update of your views & analysis?

  2. Hello Roger,

    My 2 cents worth on MMS is that if you have to level a return to achieve a suitable ROE then it is just not worth the risks.

    Just look at the worlds commercial property market not to mention the very secure income streams from infrastructure.

    We even have leveraged bond funds now.

    Just say no to debt

    • Thanks again Ashley. We are definitely in agreement. My conservative nature will always see me favour those with little or no debt.

      I don’t think I would ever classify dividends being paid out by revaluing assets and then borrowing against those inflated values as anything even remotely sustainable.

  3. Hi Roger
    Thanks for taking the time to reply. I just love the rigorous debate. I appreciate your comment about US funeral operators, but this is an unfair comparison – the competitive landscape and industry dynamics in the US are considerably different to Australia. I also point out that exposure to- and competition in- the pre-paid funerals segment means US operators are, all things considered, inferior quality businesses to Invocare.
    In the case of McMillan Shakespeare, I would only point out that placing MMS’ salary packaging business on a market equivalent PE multiple would return $6/share, which is equivalent to your total valuation for MMS. Three possible thoughts are: you place zero value on ILA, or MMS’ salary packaging deserves less than a market rating (not likely since you loved the business pre ILA) or your expectations for salary package earnings for FY11 are substantially less than our own. Just a thought. Of course, dissenting views are what create the market. Cheers, Matt

    • Hi Matt,

      How dare you use the “PE” word here! Just kidding. I should add that if the only prerequisite to being comfortable with a lot of debt is a monopoly position, then we haven’t really thought long-term enough. Regarding MMS, as I have already indicated, the quality score decline is a function of the fact that balance sheet has received the full impact of the purchase, while the P&L has only received a fraction of the ‘benefit’. But looking ahead and taking in the revised profits intrinsic value doesn’t change all that much. Its now 10 percent above my estimate of its intrinsic value and looks like it has a rocket under it, so all the best with it.

  4. sorry to ramble, one more thing…

    ‘bottom of the cycle’
    ‘opportunistic purchase’
    ‘bargain acquisition’
    ‘distressed seller’ (not quite distressed, but close enough)

    any of these are appropriate for this acquisition in my opinion.
    (and those words are not genuinely applicable to many acquisitions!)

  5. Hi Gavin

    My thinking is very much along the lines of yours (see my above posts), with the one exception being that i don’t think ILA will be generating 25% roe, my expectation is more like 10-15% (but as a shareholder i will be happy if they prove your number correct). Even so, those returns will be superior to the circa 5% returns on excess cash, and the leasing business gives the core MMS business a bigger moat from which to continue creating shareholder value.

    My reasoning behind the lower roe estimate is the relatively low barriers to entry to car leasing. If returns were as high as your estimates, every man and his dog would be getting in on it and forcing margins down – it is a competitive business and superior returns would/should be competed away (hence why i describe the business as a fairly average business in my first post, average returns on capital).

    I would be happy to hear how you came to the 25% figure if you can elaborate on it and show me what i have missed. For now however, my valuation of ILA is NTA.

    cheers

    Justin

    [roger – This post is turning into a very thorough discussion indeed! I am very impressed and commend you on your efforts to reply to everyone.]

    • Hi Justin and Gavin,

      This is precisely what I had in mind for this blog – a venue for the insights of a few to be shared for the benefit of all. Thank you for helping to make it just that.

    • Hi Justin

      I get my figures as follows.

      From the segment information in the 4E and presentation for Asset Finance:

      Total Assets = 205,587
      Asset Finance Borrowings = 112,727
      Net Assets 71,676
      Profit before Tax for 3 Months 4,573 (18292 annualised)

      Return on asset = 8.9%
      Equity Multiplier = 2.87
      Return on Equity = 25.5%

      Return on Assets of 8.9% is certainly not inspiring. But the cash flows and impairment of the assets that collateralise the debt easily support the borrowings allowing the return to be leveraged up. This is the nature of the industry. ROA is low because the cash flows and asset quality are suitable for borrowing against. If they were not Consumers would have to pay more – so that higher margins and ROA would offset lower leverage.

      As I see it MMS have strategic advantages in running the asset finance business as they are vertically integrated in relation to sourcing the leases and have free cash flow from the from the remuneration business to bolster their debt repayment ability in the toughest of times. High unemployment will be MMS greatest challenge, though a lot of their customers are government employees with more secure tenure than most.

      I suspect size counts in this sort of business, I can only see funding costs coming down as MMS grows and I suspect long term that they will have a funding advantage large enough to deter competition, except for large financial companies which in turn won’t have the same avenues for sourcing the leases that MMS has.

  6. I have a few comments regarding your thoughts on MMS. The first with respect to the calculation of ROE. Since the acquistion was only included for the q4 of the financial year, the ROE is somewhat distorted. the balance sheet includes all of the assets and liabilities from the acquisition, but only a proportion of the earnings. this number should adjusted to arrive at the true ROE for the group post acquisition.
    I also have some thoughts about the nature of debt. The inclusion of debt decreases the Weighted Average Cost of Capital and increases ROE. At some point, this declining WACC will turn turn positive again, as equity holders require higher and higher returns on equity capital to compensate them for the increased risk of default by the firm as debt levels increase. Invocare (ASX: IVC) is a case in point. The firm has high levels of debt and yet should not should not be considered a particularly risky investment. The appropriate discount rate of the firm is probably between 7-8%. Why shouldn’t we worry about the debt? The underlying quality of the cashflows and dominant market position provide a large part of the answer (For those who don’t know, IVC is the largest operator of funeral parlours, cemetaries and crematoriums in Australia. At the risk of sounding crass, dying never seems to go out of fashion).

    • Hi Matt,

      I love your thoughts on stable cash flow v debt. Can I suggest you also have a look at the big US funeral operators. I suspect ‘dying’ has been just as stable there too and yet some of the largest and most dominant operators blew up because too many debt funded acquisitions. In any event large amounts of debt cause cash to flow to banks not to owners. Regarding MMS, I agree with you. Fully accounting for the balance sheet impact and not a full year of the profit contribution can and will have a detrimental impact on the MQS ‘Montgomery Quality Score’. But I hasten to add that I don’t think the change will be significant enough to offset the negative adjustment from factors that won’t change. ROE will rise when the full year contribution is accounted for too however I do have three years forecasts for ROE so I can see what happens to intrinsic value and at this stage without substantial upgrades, the value sits around $6.00 for another couple of years. You have raised excellent points and I appreciate you taking the time to do that.

      • The original remuneration services business did not need capital to fund its growth. They retained around 40% of earnings but it was used to retire debt and build surplus cash. The remuneration business is undoubtedly a great business (albeit with a legislative risk) but it cannot be used to employ more capital.

        The ILA acquisition is capital intensive and it does require gearing to generate an attractive return. With any debt comes risk. That risk needs to be judged in light of the reliability of the cash flows and resilience of the asset to impairment. In my assessment MMS has financially structured the ILA business conservatively. Combining the leasing business with the remuneration business which throws of bundles of cash adds a strategic advantage that most other leasing companies don’t have.

        A remuneration business that arranges leases and an asset finance company that finances leases gives MMS vertical integration. This is probably the most logical acquisition that they could have made.

        They purchased at the very bottom of the cycle at fire sale prices from a company that was far more aggressive in financial structure than MMS. We have a good idea from that transaction what the assets are worth if sold under duress. With the financial structure employed and the complementary cash flows from the two business segments – I can’t see MMS ever having to sell under the conditions that they purchased.

        End of the day. I’m happy with the risk and I think the attractiveness of the business has improved. They can now throw excess cash into the ILA business and generate a 25% ROE on those funds.

        The original business has not changed and it’s ROE will continue to grow as it needs no capital to fund the growth.

        The two business segments don’t lend themselves to being averaged. I suspect if you don’t value the business segment separately then you won’t get a very accurate picture. Valuations are just opinions and my valuation/opinion is that MMS still represents value at current prices – but more importantly I think it is a quality business with very good strategic advantages and management.

        As an aside – It’s interesting that where you see deterioration in the current ratio, I see free use of money, the accruals and maintenance instalments in advance are likely to be stable/growing figures. But that’s investing for you – we can’t all agree or the market couldn’t function.

      • Really good points Gavin. Can you demonstrate a purchase price that represents “bottom of the cycle” here? Otherwise I think all of your points (apart from the valuation arguments) are valid and worth considering.

  7. Hi Roger,

    I just wanted to follow up my earlier post, as I wish to clarify a couple of things.

    (I apologise if my first post was overly critical. I had been reading some Charlie Munger before I wrote it and i think it had that effect on my writing style!

    My post was never an opinion of value, but a comment on a different interpretation of the risk of MMS. I fully agree it is no longer the bargain it once was and that buying bargains is absolutely the best way to invest, but that was not the topic of your post. The topic was its downgrade from A1 to B3 and your assessment of risk.

    The point I was trying to make was mainly that there are ample assets behind the debt and this is a helluva lot better, and very different to many other acquisitions we see in the market place.

    This is nicely put in an equities report on MMS:

    “The underlying car assets are liquid and unlike home mortgages, can be repossessed relatively simply if in default. Moreover the lessees are typically a good quality credit risk as they are often public sector employees with some insurance cover and enjoy low redundancy rates. Default history has been immaterial”

    (This could be considered the Geico of car loans!)

    You also state that you are looking for businesses whose returns on equity are going to shoot the lights out. Had i made my comment longer, I would have elaborated that I expect the core MMS business will most likely continue to shoot the lights out in that respect as it has done in the past, and that the ILA business should be self-funding and hence have no detrimental effect on the core MMS business (as mentioned in another comment by Michael Brown). Consequently, all the things that made MMS great pre-acquisition are entirely still there, and I fully expect MMS to continue creating real value for shareholders.

    With regards to the value of MMS now, i agree with you, it is not a bargain and a value investor should not add it to their portfolio at the current price.

    But, i do believe it remains the type of quality business that one should try to buy at a bargain, even with the debt it now has.

    Sorry if i have been an annoyance.

    Justin

    • Hi Justin,

      On the contrary, robust differences of opinion is precisely what we want here! You aren’t annoying anyone over on my side. I appreciate the exchange of ideas and remain open to be convinced that I am being too harsh. You are right that debt back by liquid physical assets is preferably to accounting goodwill. The stability of the value of a car however is questionable and the rate at which they depreciate is frightening. They are a commodity. A commodity whose price never appreciates (with the exception of some vintage vehicles). They get scratched, hail damaged etc. I appreciate that the business is self funding and as I say, I am open to see that I have been overly conservative. But I currently reserve judgement on whether value will continue to be added.

  8. Roger,

    It is obvious from the numbers quoted in some of the posts above, that we are often getting different results, not only to yours, but to each others too. It seems to me that there are three possible sources of this divergence, viz;

    1. The figure used for dividends paid seems to be wrong in many cases. I have found that the “cents per share” figure multiplied by the “shares outstanding” figure (ex Commsec website for example) rarely gives the same answer as the “dividends paid” figure in the company cash flow statements. (Rightly or wrongly, I use the cash flow figure.) Obviously, this will change the Payout Ratio figure in your IV calculations and can significantly effect the final IV.

    2. The ROE % figure that you choose to use in your calculation is a matter of personal selection, so two people may get a different IV simply because of that.

    3. Likewise the RR % figure is a matter of choice and also changes the IV.

    The bottom line is that if we are using different figures, we will get different answers, and some will be right and some wrong. Your advice in respect of what figures to use from company reports is much needed.

    2. Also, the POR

    • Hi Ken,

      Thanks for your post. You are spot on. The difference in valuations is always going to be attributed to different to inputs, by definition. The difference between the cash flow dividend and dividend component of the retained earnings is due to ‘declared’ v ‘paid’. I contend that as long as you are consistent over time and across the universe, it won’t have an adverse impact. The problem with the DPS versus dividend paid, is not that one is wrong. It is that you have to solve for the number of shares outstanding. By that I mean to say that you take the dividends item in the retained earnings and divide it by the DPS to arrive at the shares on issue that were used to arrive at the DPS in the first place. You will find then it is the different shares on issue that is the cause of the discrepancy. Choosing ROE and discount rates and future POR is what investing and analysis is all about. As Munger said when asked what made him such a successful investor: “my guesses are better than yours”.

  9. Hi Roger

    RYM healthcare on the NZX has been growing its dividend at the same rate as its ROE yet is paying out 50% of its profits in dividends. Contrary to your logical point in Appendix A.

    Does this mean that its true ROE is actually higher than stated due to asset re-valuations bumping up reserves. Or is it a function of its ability to recycle its capital and re-invest its customers funds in growth, interest free??

    Thanks for your help.
    Cheers
    Craig

    • I should also mention that it has never raised fresh capital or increased debt since listing ten years ago, so these are not the sources of its dividend increases (gearing less than 10%).

      Cheers

      • Thanks Roger

        In appendix A of Value.able you state the following:

        “For a company to have a 50% payout ratio and a constant dividend growth rate of 8pc the company must also have a constant return on equity of 16%. Think of it this way. If I start with $1 equity and earn 16 percent, my earnings will be 16c, but if i pay out half of those earnings as a dividend, I will retain 8c. Thus equity has gone up by 8 per cent. If, next year, I earn 16 per cent again on the new equity, my earnings will rise by 8 per cent, and because the payout ratio is also the same as last year, the dividends will rise by 8 per cent too.”

        Of course this makes complete sense.

        So I was a bit dumbfounded when I was researching a builder of retirement villages and discovered they had the following metrics:

        (average over several years)

        PAYOUT RATIO: 50%
        DIVIDEND GROWTH RATE: 15%
        ROE 15%

        Shouldn’t the ROE be 30% to growth dividends at 15% year after year with a 50% payout ratio?

        After a bit of digging (and lots of head scratching) it now makes sense:

        Under IFRS accounting standards (which the company had to adopt in place of GAAP in 2007) they have to re-value all their retirement villages every 12 months. Any movement in “fair value” as determined by a valuer is booked as income (even though its basically “air”). This ends up distorting both the reported profit and the shareholders equity (through retained earnings from an artificially inflated reported profit and additions to the asset revaluation reserve).

        Luckily, the company also states a “realised profit” for the benefit of shareholders to show what their underlying cash profits really are and they are careful to explain this is the number that shareholders should focus on.

        So instead of using an ROE from the financial statements, I calculated the actual invested cash taking the original issued funds, and added 50% of the “realised cash profit” (NOT the reported profits) for each year.

        And of course, the “real” return on funds invested and retained by the company is indeed running at 30% year after year.

        Due to changes from GAAP accounting to IFRS that they adopted in 2007, quite a bit of time (and patience) is needed to get to the bottom of the numbers… but its worth it.

        Bearing in mind the difficulties in getting to the bottom of the accounting, I would be interested in your MQS on (name withheld) Roger… I would be pretty suprised if they were not an A1.

        A company that can grow at that rate for over a decade with almost no debt and never going to the market for fresh equity is doing something very right.

        If any of this analysis sounds wrong, please point it out.

        With regards,

        Craig

      • Hi Craig,

        Given its an offshore company (for us) and I don’t know the personalities involved, I have withheld the name. I have no intention of nor interest in buying it myself. I will nevertheless have a look as you have suggested and if its worth covering will do so here on the blog AND reinstate the name. Thanks Craig for the suggestion.

      • Sure Roger

        With hindsight I think you are right to do this, as without some easy but critical adjustments I don’t think your model will not work “out of the box” on this one.

        How about using this company as an example for a post to show a more problematic company to analyse, and what adjustments are needed, and the resulting valuation? That would be both very interesting and informative for all your readers??

        I still live in hope you might do an entry on Austin Engineering one of these days as we have discussed a few times! :)

        Keep up the good work. With regards,

        Craig

      • Hi Craig,

        I keep a list of every company that has been requested. Obviously the list gets bigger every time I am diverted to something else, but its my hope that after completing all of the analysis from reporting season, I can publish a list with the bulk of those that have been requested.

  10. Hi Roger,

    Just wondering about your view on Thorn Group (TGA)

    I got an intrinsic value of 3.12. Is this around right?

    Thanks

  11. Hi Roger,

    When I studied M&A Law at college, the first thing my tutor said was that there was no real evidence to show that M&A activity was beneficial to anyone (except advisors). Reviews dating back several decades reveal that growth and profitability of the buyer rarely outpaces the growth that could have been achieved organically. In fact, M&A often resulted in a severe destruction of wealth. The culture of the CEO is just not the same as the culture of an investor. I remember feeling more than a little disappointed as he said “Now, on with the course!”

    In my opinion, while this acquisition isn’t a disaster, or even especially dangerous, it signals the end of one era in the life cycle of MMS. Unfortunately for all of us, I believe that period was the best time for shareholders.

  12. Steve Moriarty
    :

    Hi Roger,

    Thank you for the assessment of MMS. It is always useful and you provide much food for thought.

    I bought MMS at around $3, so the capital gain has been wonderful. If I consider the dividend return then it is approximately 7%. A good return in the current climate.

    MMS is obviously a good company but there comes a time when all companies other than those that have a large moat or sustainable competitive advantage see their profits revert to the mean. Maybe the time for reversion is upon MMS?

    Justin makes some very thoughtful points in their favour and I myself think MMS has a bright future. I think the demographics and the importance of superannuation will play a greater role in many lives and as such they are probably still a good investment.
    But are they an exceptional investment that is undervalued?

    If I consider my own thoughts, it is always emotionally difficult to part with a “friend”, especially one that has been so generous and given you a large capital gain. But as you state, the debt level is now something that if you were currently looking at MMS as a buy proposition, the debt level would immediately ring alarm bells.

    So although they are a great company and in all likelihood have a good future, they are no longer “undervalued” as therefore probably not a buy. If I consider the dividend, then I have to ask whether there are better returns (capital and dividend combined) and I think the answer is yes. So although 7% is a nice dividend, and they may grow at a steady rate, I believe that there are some opportunities where the capital could be utilised to generate greater capital and dividends returns in the future.

    I would be interested in your thoughts whether you support the concept of “taking some profits” but still maintaining some interest?

    Regards
    Steve

  13. Hi Roger

    Just read your book and its great!

    I been doing some intrinsic value calcuations and I have come to a return on equity for wotif at 84.2%. What do I do because the higest vlaue on your table is 60%.

    • Hi Leon,

      The model in the book is of the straight line variety and so the ROE use you adopt is the one that you expect to be sustained for the foreseeable future. Its very rare to see rates of return on equity of more than 60% and even rarer to see those rates sustained. The book deliberately forces conservatism.

    • Leon,

      Whether you use LY equity of 71.1 or an average of TY & LY (85.9 + 71.1)/2 = 78.5, the ROE is not 84.2%. It is more like 67% using the average equity approach.

    • Hi Tim,

      Thanks for the question Tim. I am not sure about the exclusivity they have in the contract terms with retailers like JB Hi-Fi Ltd and Dick Smith – relationships that have been extended through to mid-2012 and the end of 2014, respectively.

      Management could be another source. The suspension of the dividend was interesting given the company has no debt and could indicate sensible management – retaining profits in anticipation of higher rates of return on equity (which is preferable to paying dividends and then issuing new shares or borrowing money).

      • In TSM’s recent results presentation, they explicitly state that they have growth from cashflow rather than debt as one of their core principles. This could be a company that can actually explain their dividend policy if asked – ie. pay dividends when they have no more beneficial use for the cash. I suspect the market took the decision not to pay a dividend as a sign of trouble which was commonly the case recently, but unlike many examples in the past two years, this company is not wallowing in debt. Therefore, it is keeping the cash to fund its expansion, not just to stay alive.

      • Hi Greg Mc, Its great to see so many investors now subscribing to the sensible capital allocation principles outlined originally by James Walter, adopted by Buffett and articulated in value.able!

  14. Hi Roger,

    I notice that TRS’s debt:equity has risen significantly too (now over 50%), which creates a dilemma! Normally I would not purchase businesses with a ratio > 50% but TRS is otherwise a great business. Maybe they will pay off the debt quickly? – not so many openings planned this year.

    This brings me to a question your book raised – what do you consider “little or no debt”? Obviously the less the better for all the reasons you expound on, but is there a cutoff that eliminates businesses from your search?

    Regards,

    TC.

    • Hi Tim,

      Regarding TRS – Debt went up and ROE went down (albeit every so slighlty)

      This actually means that the shareholders funds were not enployed as well as the past year.

      This may be a blip but it is the first warning sign that the quality of profits going forward may not be as good as the past.

      Nothing to panic about just yet but certainly something to keep an eye one

  15. Very interesting article Roger, I would be inclined to agree with you – Correct me if I am wrong but most of your A1s have reported healthy profit increases this reporting season and share prices have generally moved higher based on the fundamentals, this against a market that has been trending down.

    When I read this article I thought of Billabong who I considered to be an A1 up until probably 2008. Since then its ROE and share price has nearly halved. I don’t think it is because of the GFC either, I suspect its because of all the over priced acquisitions it has made (check out the latest one on West 49 – no profit for 2 years and they paid $100m for it and claim it will be EPS accretive, how is that even possible). Interested in your thoughts on BBG as I am sure many other owners of it who read your blog would be. Anyone who manages their own portfolio should read your book! Cheers

  16. Hi all,

    Regarding this line from Justin’s post… (and BTW I like much of what you wrote Justin)

    “… an asset intensive business such as a leasing business must necessarily be financed with a large chunk of debt so as to earn adequate returns on equity.”

    If this is true then let us all avoid such businesses like the plague. Surely it is the job of us investors to find businesses that can generate high returns on equity *without* the need for large amounts of debt!

    How long will it take us to learn, large amounts of debt are bad news. At worst, it can bring multi-billion dollar gorillas to their knees, at best, it gives the illusion (think of ABC learning) of a business that is growing stronger as their revenue increases. To me, large amounts of debt involves an element of speculation in my mind.

    I’m loath to quoting Buffett, but I am compelled to…
    “There seems to be some perverse human characteristic that likes to make easy things difficult.”

    Buy reasonably priced companies with low Debt/Equity *and* sustainable high ROE.

    Cheers,
    Andy

  17. Thanks for your comments Jason we all apeciate your thoughts.

    I view investing like a football coach thinks about his team.

    You only wont the best on your team that you can afford with the resources available.

    The advantage that investors have over the footbal coach is they don’t have to have a roster of 20- 30 players.

    They can have just the best, This is more than likely much much less than the roster of a football team.

    Some of your players may continue to be absoultely brilliant for decades. But some will not be as good and will do things that will not be in their long term best interests.

    The problem that the football coach has is that he has a roster of 20 to 30 . The coach may or may not keep him on the roster.

    For the Investor if a bright prospect is avaialble at or less than your current player, then you can very simply switch to something better.

    You don’t have to keep the player.

    Only you can decide if MMS has done something silly and brghiter prospects are available elsewhere

    As as investor you don’t have to have a full roster.

    You only want the best.

  18. Hi Roger

    A strange coincidence – MCE mentioned through blog/Eureka/Sky, and lo and behold, up 7ish% today…

    The Speculator’s portfolio additions often appear to rise after his Eureka article too…

    Looking forward to the next addition to the Valueline portfolio!

    • Hi Mick,

      I would be deeply disappointed to discover people buying stocks just because I mention them. I wrote a post here some time ago asking whether investors used the TV as their source of advice – YOU SHOULD NOT! Warning, the shares of MCE could halve tomorrow. I have not bought them because I think they are immune to a big decline. Watch out all of you have bought without research and without advice. I could change my mind and sell the shares tomorrow and I am under no obligation to inform you here or anywhere else. Do not buy shares without first seeking and taking personal professional advice.

    • You’re right, Mick, though there was a couple of days lag between the blog/Eureka mentions and the big jump on Friday. Still looks like risk taking behaviour all the same, the exact opposite of what Roger tries to instill!

      • Hi Gents

        It was just a comment on what seems to be a pattern I’ve noticed re media recommendations and share prices. I only have the basics re TA but always wondered if there was a pattern there and if so, how would you trade it? I’m not sure there’s an answer but it’s fun to think on these things sometimes!

        RE MCE, I’m not sure if we’ll ever know (or can know) how much of it was risk taking behaviour or well considered investing?

        If people bought MCE just because Roger mentioned it, then I agree with Greg that’s risky. If people heard Roger mention MCE, then followed up with proper investigation and (if financially appropriate) then safely purchased, that ‘s alot less risky, and perhaps even wise? I can only hope it’s mostly the latter.

        I say let the tips flow freely – bring ’em on; it’s your choice as an investor as to what you do with the information. The Value.able tools are there so it doesn’t take long to know whether a business is worthy of further detailed investigation and possibly an eventual purchase. I do not understand how you can act without first investigating, but perhaps that is the cynic and skeptic in me.

        I had alot fun with this idea when I first started looking into investing, and anyone can try it at home without threat of injury or financial loss:

        Keep a list of media tips and tipsters (I used watchlists) and see how they perform over time; same for broker recommendations…

  19. Roger,

    Cheers for this post, but I think we will have to agree to disagree on a few things.

    To begin, I do think that the acquisition itself was of a fairly average business. A leasing business is largely a commodity business, so average returns on capital are probably the best that can be expected.

    I can however take comfort in the fact that the price paid for the business was probably as low as one could realistically hope for at below NTA. As you and I would probably agree, the fact it is ‘earnings accretive’ is irrelevant. An inferior business deserves to trade at a lower multiple and I would never pay more than book for this one.

    Further, whilst it is a commodity business, it would seem that within the market it operates it is of a relatively large size and is associated with good brands. I would be very cautious to say it has a material competitive advantage, but I am happy that it is not at the bottom of the food chain either.

    Now onto the debt, an asset intensive business such as a leasing business must necessarily be financed with a large chunk of debt so as to earn adequate returns on equity. That is the nature of the beast (which I also appreciate is why we would consider it an average business at best). Hence, significant licks of debt should not cause great concern in this instance as the debt is supporting real physical assets that are not about to disappear anytime soon. These assets can also be sold in a relatively liquid market (compared to other P&E anyway) if things start to go wrong.

    I still appreciate that this does not make it ‘absolutely’ safe. If the economy turned really bad, the price for second hand cars would likely take a hit and achieving a fair price for those assets could be difficult. Nonetheless, they are there, they are tangible and most importantly they cap the downside to a very real extent. So the acquisition is considerably different from one involving payment for ‘growth and goodwill’.

    Now onto the synergies. I would like to think that I treat this word with a very healthy degree of scepticism. But, in this instance, I am going to give management the benefit of the doubt. Mr Podesta still has a very material chunk of wealth in this business and, while he is no longer ‘management’ in the strict sense of the word, I very much doubt he would allow the business to enter such an acquisition lightly. His interests are as aligned with my own as much as I could possibly hope for.

    Comparing the second half results with the first half results for the standalone MMS business shows a very large amount of earnings growth. Historically, the second half has always been stronger in this business, but not this much stronger. Further, it should be remembered that any synergy benefits flowing from the acquisition have only had 3 months to play out. Consequently, I am cautiously optimistic of how things will look in the next half year result as it would seem that the oft touted synergies are actually real for a change.

    So, is MMS the pure cash machine it once was…. No. You are correct in that respect.

    But, it is not a significantly riskier proposition either. The core business remains a cash flow beast, but instead of having a big cash balance on its books, it has a lot of cars financed with an APPROPRIATE amount of debt. The return on the equity supporting those cars is not going to shoot the lights out, but I can already observe favourable effects flowing to the core business.

    I am worried your blog readers now look at MMS as a particularly risky business following its downgrading in your quality scores, unnecessarily dropping a high quality business from their list of potential investments (well, not really since it puts selling pressure on a company I like!). But in the interests of investor education, the point I would make is that while applying a strict one size fits all approach definitely helps you to quickly focus on the best companies, it fails to provide an understanding of situations like this that must necessarily be considered in more detail, so as not to miss the true nature of the situation. Watch out for man with a hammer syndrome!

    Cheers

    Justin

    • Hi Justin,

      Thank you so much for your very considered response – its longer than my post! Well done. First, I should say that I don’t want you to get the impression that the acquisition was of a ‘fairly average business’ as you put it. I did say that “many will argue that MMS generates huge cashflows and that it still produces excellent (albeit highly geared) returns on equity and it should therefore have no concerns in meeting its interest expenses and maintaining its current capital structure for the foreseeable future. While this is all true, I always prefer to reduce risk in my portfolio by owning extraordinary businesses.” Its just that my investment process prevents me from investing in anything with more than little or no debt. If you are saying that the debt has the same conditions as a car dealership, I will be happy to look at it, but I don’t think so. With regards to your concerns about the one size fits all approach – I think its safe to say that the combination of quality and value has worked pretty well.

      Given that MMS is now trading above my intrinsic value I am just as happy standing aside again. Like Buffett, I may make the mistake of having to buy back in at a higher price but so be it. Keep in mind I would be delighted to be further convinced.

      I am looking for businesses whose returns on equity are going to shoot the lights out.

      Please remember that a a market is made up of buyers and sellers and at the point of every transaction the buyer arguably disagrees with the seller. Its something you have to get very used to in investing. if we all agreed there would never be a trade.

      • Pat Fitzgerald
        :

        Hi

        Using a forecast EPS of 53 cents I get an intrinsic value of about $6.00, therefore I would have to wait until FY 2011/2012 until my IV is above the current trading price. Therefore there is no compelling reason to buy at present.

  20. Great Analysis, I just received your book and I have an 8 hour flight this weekend so can’t wait to dig in.

  21. Dear Roger,
    I read your comments on MMS with some interest. We analyse MMS closely and work with management. I would appreciate the opportunity to meet with you to discuss your views. I believe your opinion might not fully appreciate the quality of the cash flows at MMS, the ring fencing of the salary packaging cash flows and the self funding nature of ILA. I am based in Sydney and would be pleased to come to your offices to discuss.
    Kind regards,
    Michael Brown

    • Hi Michael B,

      I would be delighted to chat. As I said in my post the cash flows are indeed strong – I don’t disagree, but its the premium to intrinsic value now that is a material consideration too. I will give you a call over the weekend for a chat.

      • “would be pleased to come to your offices to discuss”

        Gee, we can also disscuss mms in this blog. Instead of the closing door.

        My understanding is that it is not management’s intention to keep the debt for very long, they thought this asset was cheap and want sell it partially afterwaords and build marketing position in car leasing/salary packageing maket. Create value for mms shareholders in the process.

        $6.00 price level, I hold it.

      • Thanks Nan.

        I would like everyone to know that I receive all views with an open mind. My job is to get it right not to think I am always so. Its entirely appropriate that a broker has the opportunity to share his house view any way he prefers. If we don’t accommodate the different ways people like to communicate, they won’t communicate. I am looking forward to seeing another view and perhaps having my mind changed too.

  22. Hi Roger,

    Interesting take on it – there is so much BS out there and its refreshing knowing that when I read your blog, you are rational and logical. I read all of the MMS report and have the same concerns that you have. Would it be reasonable for MMS to reduce the dividend and pay off a large chunk of that debt? As a shareholder, I would be more than happy for that to happen.

    Their acquisition to me seems like it will benefit the company as a whole. What is your take on the value compared to what they paid for ILA?

    Either way, I am going to continue holding my MSS shares. Hopefully they reduce their debt this financial year.

    • Hi luke thanks for your thoughts

      MMS have a ROE of let say of 30% and debt funding of let us say 9%.

      If you use reatined earnings to pay off debt then ROE must decline.

      You would have read Roger’s Book regarding capital raisings to pay off debt being dilutionary to existing shareholders. If you have a high ROE and you use shareholders funds to pay down debt then this is dilutionary as well. Not as bad as a capital raising but it will reduces your wealth.

      The easy way to solve this is Invest in entities with little or no debt.

      • Can I just qualify Ashley’s comment on dilution of returns with debt repayment? I enjoyed Roger’s book and understand where Roger is coming from with respect to the use of capital raisings to pay off debt. The returns from such raisings can only ever be as high as the cost of servicing the debt.

        However, if the debt is used to purchase an investment at a price far below its intrinsic value, then could not the debt repayments come out the same sort of returns that one would gain when buying shares at prices below intrinsic value?

        In other words, paying off any debt using shareholders’ funds is dilutionary but must be weighed up against how much more wealth the debt had generated, i.e. what is the net gain to the shareholder.

        I agree with Roger that MMS’ move uncharacteristically takes on a lot of risk. Roger’s position rightly looks to protecting one’s investment first. On the other hand, that does not mean MMS is making a bad move either, It just means we are moving into the realm of speculation (will the ILA acquisition work out or won’t it?).

      • Hi John,

        Thanks for the clarification. You are right to point out the first order priority is protection of capital – rule #1 don’t lose money. I also agree that the purchase of a business below intrinsic value with debt can work out really well. Its just the I prefer the purchase of a business below intrinsic value without the use of debt. Thats all.

  23. Pat Fitzgerald
    :

    Hi Roger

    I think they have about $200m worth of ‘leased’ cars as non-current assets, how would we treat these. Can they be partly offset against the borrowings or do they play no part in analysing risk ?

  24. Good summary of the change in MMS’ situation. I have a request to make: is it possible for us to analyse JB Hifi along the same lines back at a time when it had a lot of debt? It might be helpful to track JB Hifi’s evolution into an A1 business.

  25. Hi Roger,

    Firstly thank you for the book, I think you should be proud humbled by what you have produced and the impact it is having on so many peoples lives, mine included.

    I saw you on Sky Business last night and noted you mentioned that Platinum Asset Mgt is trading below IV – this hit me like a sledgehammer as I had just yesterday attempted to value this. Based on their Jun10 results and using, EQPS of 0.40, RRR 11%, payout of 95% with ROE of 60% – i get a max IV of $2.53….a long way short of it currently traded price of 4.70.

    Can yourself or one of the more learned members of this community please help me as to where I am going wrong….I am at a loss and am completely doubting myself now!

    Thank you all again for your impact on changing my approach and helping me see the wheat and the chaff!!!

    Regards
    Scott

    • Thanks Scott,

      Lets open it up to someone else. My valuation is only a few cents above the current price. And please remember the caveat that stock markets rise or are benign.

      • Hi Roger and Scot,

        My IV of PTM is simmilar to Scot’s. $2.78. Roger, Please explain how you arrived to yours

      • Roger/Scott,

        I suggest that to get IV anywhere near the current price you have to believe those questionable analysts forecasts that earnings (NPAT) will grow 25%-30% year over year (2011/2010). This equates to a minimum 2011 NPAT $171 million vs $137 million in 2010. This increased profit would drive ROE from ca. 60% to ca. 73%, while equity in the business would grow by 8.25%, all of which has a big effect on IV.

        All other things being equal (by way of cost structure and management fees take), this requires that average funds under management (FUM) to rise by at least 15% year over year. In my view this is a bit of an optimistic ask in the current climate. Any global equity market downturn will hammer this (FUM) key driver of the business earnings and thus ROE and thence IV.

        Hence the need for a good margin of safety.

        Regards
        Lloyd

      • Hi Lloyd,

        I am using $160 million and 89% payout ratio. In my book I discuss “implied growth rates” and so you are right; big margins of safety are always required. As I said on TV, it is based on a benign view about the markets.

      • PS to the previous post: most would probably value the business on a 10% RRR and the payout ration is likely to be 90% or slightly less based on the analysts view of things. Both of these (relative to Scott’s assumptions) have a significant impact on valuation at the high ROE attached to this business.

      • Hi Roger,

        Thank-you for sharing your experience, it’s much appreciated.

        Most of my IVs matched to within 5% of your recent estimates (which is heartening) on Switzer, PTM and WOW however were markedly different. Based on WOW latest results and using, EQPS of 6.31, RR 10%, payout of 70% with 25% ROE – i get an IV of $20.82. Quite different to your IV of 26.18.

        Changing the ROE to 30% however produces an IV of 26.81. I’m wondering if this is in fact the difference of our inputs. Or something else?

        I looked again at PTM’s annual report and still can’t figure it out though.

        Regards, Deb

      • Hi Deb and Roger,

        Here is the way I calculated the IV for Platinum. I get $2.85. Don’t worry, I have a PhD in Maths…but I have also had a few Sunday beers:
        Using Book value: $0.40
        Payout Ratio: 94%
        ROE: 60%
        RR: 10%

        So unless you assume that the payout ratio is lower, I cant see (by Roger’s IV method) how you come up with the higher valuation. I did get those values from Commsec instead of their financial report. Perhaps Commsec made a mistake?

        Roger, speaking of beer, I hold LWB from a few years ago when I had no idea what I was doing. They have returned a very nice capital gain for me and now have a good dividend yield – what a fluke! I value them at about $1.20ish which is far above their current trading price. The question I have is what rating would you give them? They have growing ROE (and is now above 20%) as well as low enough debt and a great product. By far, I enjoy doing “market research” on LWB more than any other business.

        This has been a very interesting thread on MMS. Thank you to everyone who has posted about them!

      • Hi Luke,

        The beers might have caused you to forget to define a couple of the inputs. Do you want to have another sober go? Regarding Little World Breweries (yes I have a bunch of friends who enjoy researching this company especially on weekends – I am forever telling them to stop working!) I get a valuation of 97 cents. I think you meant to say that the value was far BELOW the current price rather than “far above” (Sunday beers?). Looks like the shares have got a bit of a head on them that needs to settle down. Middling B2 for MQS (“Montgomery Quality Score”).

      • Thanks for the reply, Roger.

        Yes, looks like those Sunday beers ruined my post a little :) I ended up selling most of my LWB shares simply because they are overvalued and I can’t see their intrinsic value getting up to the current price in the next 3 years.

        I am still trying to get to your valuation of PTM. I have gone through their financial report and get these figures:

        NPAT $136852
        Equity 2010 $225398
        Equity 2009 $194135
        Total Shares 586684 (this is the figure used for the diluted EPS calc)

        EPS 23.33
        DPS 22

        The thing with PTM is that they have a great ROE but they pay it all out as dividends.

        I get:

        An ROAE of 65.24% vs 60.7% in commsec – Clearly they use this years book value to calculate it which is naughty.

        2010 book value of $0.38 vs $0.40 in commsec

        Payout ratio of 94.3% vs 94% in commsec

        After all of those, I end up with a valuation of a bit over $3 compared to your $4.95. What am I doing wrong?

      • I’m new to this IV stuff as well and also after hearing about PTM on fox business channel and seeing PTM in your valueline portfolio in the ‘Eureka Report’ (only being a subscriber for a few months but very impressed so far) I too wanted to have a go at doing my own IV using the my awesome “Valueable” companion and came up with a figure around $2.80 using westpac broking 2010 figures hmmm?? After reading the above post and then finding thier annual report on the ASX website I noticed that in the top 20 shareholders it looks like they are listed as number 1 ??? what the ? If you take the total number of shareholders for year of about 561.3 mil and subtract the shares PTM own in themselves then an IV of about $4.75 is achieved……is this what you allueding to and am i off with the pixies !!???

        Thanks for you time again

        Darren

      • Hi Darren,

        I think you will find the name of the largest holder is a PTY Ltd company – the private holding company of the founder. Regarding the valuation, I can only get the circa $2.50 number if I assume all earnings are paid out, which they are not.

    • Pat Fitzgerald
      :

      Hi Scott

      I think your calculations are probably correct when using a RR of 11% and when using data for the 2010 FY. For the larger top quality consistently high performing businesses you could probably use a lower RR of say 10%. But that is a personal choice. Also I assume that Roger was quoting the FY 2010/2011 intrinsic value. Rogers table stops at 60% but he may have used a higher ‘forecast ROE’ or even a RR of 9% but that does not mean that we have to. I get a ‘2011 IV’ below the current price but I think that Roger is probably also using different forecast EPS to mine and you may have different ones to both of us. Keep practicing on different businesses, I have found that forecasting the future POR and ROE to more realistic values is one of the keys to IV’s I trust.

    • I am having the same issue as Scott. EQPS of 0.40. Payout ratio of 90% and ROE of 65%. Even with a generous 10% RR, I only get an IV of $3.16. Clearly PTM is not a bargain at current prices but I can’t work out why my IV is off by 50% compared to Rogers IV.
      Help would be great!

    • Scott,

      You might check your dividend payout figure. They paid $112.2 dividends against a NPAT of $136.8, which results in a POR of 82%. Other than that, I was also puzzled when I heard Roger say that. I get an IV of $3.33, which is probably what you will get when you adjust your dividend payout figure, and that is still well short of their current trade price.

      • For what it’s worth my valuation of PTM is $4.54.

        I use a slightly different model to Roger’s.

        Remember all those guys who got low valuations your are neither right nor wrong just because peole agree or disagree with you

      • Thanks again Ashley. I have had a look at your model too. Thanks for sending it through. It produces the same results as Walter’s model with marginal changes for different tax rates. Well done. I think its ok. if you are happy to publish it here, thats fine also. Let me know if you’d like to.

      • I am happy to have the model put on your blog, I don’t mind sharing as you, the book and this blog have given me plenty and I now consider myself, without trying to be overly modest, an above average investor.

        It is no secret, and is a good quick and dirty for amatuers like myself.

        It does have it’s limitations particularly with capital raisings and share buy backs and as you know it is different to yours.

        I have been meaning to tidy it up so that you just input forecast EPS, equity per share, and DPS. ROE and Payout are automatically calculated.This is for the really lazy blokes like me. I will email this to you.

        After I done my research and I am keen to do something my last process is to read my list of Buffet quotes. It is only then that I do something.

        There are hundreds of Buffet quotes but the ones on my list are to cover me from an emotional decision that I have made in the past. I will email this to you if you like and you can decide if you want to post this as well.

        I think the bloggers may get something out of this as well.

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