Ann: Half Year Results Commentary , page-9

In my experience, when it comes to investing in “turnaround situations”, such as COF, most people are overly focused on the P&L....which is good and well, but which unfortunately misses the essence of the investment opportunity in COF.

As I have opined hard and often, on their own P&Ls at the are reasonably unreliable barometers of shareholder value creation, and require a degree of scrubbing and sanitising in order to arrive at “clean and pure” financial performances metrics.

This is even the case for companies operating at "normal", steady state conditions, but for companies undergoing significant transition and restructuring, the P&L becomes even less reliable due to the distortions of legacy factors; for example, changes in depreciation policies as well as depreciable asset bases, the capitalisation of interest as well as non-interest charges impacting the finance expense line, restructuring charges taken above the line, the raising – and reversing – of provisions, tax losses, and all other creative accounting alchemy, mostly invoked for the benefit of incoming executive teams brought in to replace the ousted executive team whose misadventures brought the company to the point of requiring the said restructuring.

Which is why, when evaluating turnaround opportunities, I think it is far more instructive to look at the CAPITAL BALANCE of the company, specifically in the context of its capital structure (which, when a company gets to the point of requiring “restructuring”, is usually bloated with debt and is what brought the company to the point of maximum pain in the first instance.)

Put another way, I think what is far more important than the absolute level of that arcane quantity called “NPAT”, is the relationship between the following:

• Net Interest Bearing Debt (NIBD)
• Market Capitalisation (Market Cap)
• Operating Cash Flow (OCF)
• “Stay-in-Business”, or “Maintenance” Capital Expenditure (SiB Capex)


It stands to arithmetic reason that, for a constant EV/EBITDA or EV/EBIT multiple, for a company that has:

a) Significant NIBD relative to its Market Cap
b) A high ratio of OCF to SiB Capex, i.e. it generates FCF, and where
c) that FCF is material relative to the company's NIBD

the following will occur:

1. The FCF will be deployed for the purposes of reducing NIBD (invariably, this is a constraint placed on the company's executives by the company's own bankers as a condition of relaxing covenant arrangements during the "turnaround" phase).

2. As the NIBD falls, the Market Cap has to increase by the same nominal amount in order to satisfy the condition of constant EV multiple(s)


For illustrative purposes, let’s take a few hypothetical examples:

Company X:
Market Cap = $1.2bn
NIBD = $1.1bn
OCF = $280m
SiB Capex = $180m

In this case, NIBD is almost the same as Market Cap, and FCF is slightly less than 10% of NIBD.

So, given our assumptions of EV multiples – and hence EV – held constant, after one year, the NIBD will fall by $100m, and hence Mkt Cap will need to rise commensurately by $100m

So, without anything else happening, Company X’s Market Cap will rise by $100m, or 8%.

In other words, without any improvement whatsoever in underlying operating performance, or any re-rating of the valuation multiple, the simple de-leveraging phenomenon delivers a "mathematically guaranteed” 8% return.


Take another example:

Company Y:
Market Cap = $50m
NIBD = $150m
OCF = $50m
SiB Capex = $35m

In this case, NIBD is a multiple of Market Cap, and FCF is also equivalent to about 10% of NIBD.

Now, given our assumptions of EV multiples – and hence EV –held constant, after one year, the NIBD will fall by $15m, and hence Mkt Cap will need to rise commensurately by $15m.

So, without anything else happening, Company Y’s Market Cap will rise by $15m, or 30%.

In other words, in this case without any turnaround in underlying operating performance, or any re-rating of the valuation multiple, the simple deleveraging phenomenon delivers a "mathematically guaranteed” 30% return.


A few important qualifying caveats are warranted at this stage of the discussion.

Firstly, as indebtedness is reduced in a business, so is financial risk, and as financial risk is reduced, valuations multiples tend to expand.

Second, this example assumes simple debt reduction in a single given year without acknowledging the virtuous cycle of lower debt translating into lower interest expense in the following year, which in turn means higher levels of OCF, and hence higher FCF, and therefore an acceleration in the debt reduction ability of the company.

This then implies that this sort of “single-year”, constant valuation multiple analysis tends to be quite conservative.


So, in summary, it should therefore be somewhat self-evident that the capital balance of a company, and the make-up of the capital structure are significant determinants of prospective share price performance in turnaround situations, far more so than whether the company “hits” or “misses” some or other unreliable NPAT number.


Which brings me to COF’s result today:

The thing that stands out for me, as it did for others it seems, is the FCF of $9.7m for the half (OCF of $13.7m and Capex of $3.9m).

This was achieved on the basis of working capital management that reduced year-end Working Cap-to-Sales to a near all-time low of 11.5% (for context, JH12 it was 14%, and DH11 it was 13.9%, which is in line with the company’s long-run average of 13.5%)

Now I fully acknowledge that there is a risk that this working capital achievement reverses to some extent in upcoming financial periods, or at best, does not improve any further.

So sceptics might argue that OCF in the half was boosted by around $7m due to the 200bp reduction in Working Cap as a percentage of Sales.

However, offsetting this is the fact that over $5m in restructuring provisions raised in FY12 were funded in cash in the December half.

So I would argue that the “normalised” OCF for the half would be around $13.7m add $5m less $7m, which equals some $11.5m to $12m (for FCF of $7.5m given Capex was around $4m).

Annualising that figure (and I think one can, especially given EBITDA in the current half is expected to be up on the DH), gives the following situation for COF:

Market Cap = $98m
NIBD = $58m
OCF = $23m
SiB Capex = $8m

In this case, NIBD smaller as a proportion of Market Cap than our examples of Companies X and Y, but FCF as a percentage of NIBD is significantly higher, at around 25% of NIBD.

(As an aside, it is not lost on me that COF's OCF/Capex ratio of almost 3x falls into in the top quartile of listed companies.)

Now, given our assumptions of EV multiples – and hence EV –held constant, after one year, the NIBD will fall by $15m, and hence Mkt Cap will need to rise commensurately by $15m.

In other words, without anything else happening, COF’s Market Cap will rise by $15m, or 15%.

In other words, in this case without any turnaround in underlying operating performance, or any re-rating of the valuation multiple, the simple deleveraging phenomenon delivers a “mathematically guaranteed” 15% return for COF.


However, as I hinted earlier, what will happen in reality is that the market will, as COF’s balance sheet increasingly de-gears, apply a higher rating to the stock as an act of risk aversion reversal.

Additionally, the “15% pa mathematically guaranteed return” is derived on the assumption that no improvement in underlying profitability occurs.

Yet we know that management are flagging improvement in underlying EBITDA in the current half due both to internal cost savings (the ones that will arise following the $5.1m cash outflow in the DH for restructuring), as well as a recovering in demand from some of COF’s economic segments.

So I have conducted an exercise where I have considered 4 scenarios for potential return over the next two years from an investment in COF.


SCENARIO 1:
- As described above: No earnings uplift in FY14 and FY15 from the $33m I am forecasting for FY13
- No re-rating of the stock from its current EV/EBITDA multiple of 4.5x
- Resulting Return = 14% pa over FY14 and FY15, or 30% share price appreciation by 2015

SCENARIO 2:
- Modest (3% pa) EBITDA recovery in FY14 and FY15 from the $33m I am forecasting for FY13
- No re-rating of the stock from its current EV/EBITDA multiple of 4.5x
- Resulting Return = 19% pa over FY14 and FY15, or ~40% share price appreciation by 2015

SCENARIO 3:
- Modest (3% pa) EBITDA recovery in FY14 and FY15 from the $33m I am forecasting for FY13
- Modest re-rating of the stock to and EV/EBITDA multiple of 5.0x from its current EV/EBITDA multiple of 4.5x
- Resulting Return = 27% pa over FY14 and FY15, ~60% appreciation in share price by 2015

SCENARIO 4:
- Cyclical EBITDA recovery of 10% in FY14 from the $33m I am forecasting for FY13, followed by 3% growth in FY14
- Modest re-rating of the stock to and EV/EBITDA multiple of 5.5x from its current EV/EBITDA multiple of 4.5x
- Resulting Return = 41% pa over FY14 and FY15, or near-doubling of share price by 2015

[Note that this exercise is intended to be indicative, rather than prescriptive, and should not be construed as investment advice.]


Listening to the webcast today indicated to me that the worst is over for COF.

Under what was clearly challenging business conditions, I think this is a most credible finanical result and a manifestation of management sticking perfectly to the “turnaround script”, i.e., in following a strategy of:

1. Harvest the Surplus Capital
2. Pay Down the Debt and
3. Let the Bottom Line Fly

On that note, I think it is worth noting that COF has repaid $22m in debt over the past 12 months alone ($14m of it from surplus capital generation, $8m from sale of assets).

For context, $22m is over one-fifth of the company’s current Market Cap and is 15% of its EV.

And that CAPITAL BALANCE consideration, I believe, reflects the essence of the investment thesis for COF.


Prudent Investing


Cam

PS. Company X and company Y are not completely fictitious; they are based approximately on existing companies that reflect similar “CAPITAL BALANCE” turnaround situations to COF.

Bragging rights for anyone who can guess their respective names.