cof cof cof !, page-13

March, the tone of your post makes it sounds like you're an anxious owner of COF, due to what you perceive to be a capital deficiency.

I perceive quite the opposite: in fact, the company generates surplus capital right through its business cycle and is approaching - ceteris paribus - a position of EXCESS capital, in my view (and I strongly suspect in the view of the board, the company's bankers, both current and prospective.)

Let's look at some of the metrics:

Firstly, what does a lender look for? It looks for certainty that the borrower will be able to service the interest and repay the loan - or refinance it - when it falls due. Often this certainty takes the form of security over physical assets. But what if a company has a negligible hard asset base? Does the bank then simply not lend? Not at all. The only difference is that the strength and reliability of the cash flow stream becomes the basis of the certainty the bank is seeking. Hence, the term cash flow lending.

Think about it for a minute from the standpoint of the banking industry, especially one that operates in a developed country like Australia where the service sector is a significant, and growing, component of the economy, at the expense of the manufacturing sector. Service companies, by their very nature, tend to be asset-light, invariably they are "people businesses", with employees sitting in front of PCs (which depreciate very quickly and make for very poor collatoral, by the way), in premises that are leased.

Banks are mandated, inter alia, to grow their loan books; it is their key growth KPI. So if executives of a bank one day decided to lend only if the loans could be backed by a "liquidatable", tactile asset such a property or a factory, they would soon find their potential customer base not just static, but shrinking. Definitionally, it would be very difficult for a bank to prosper under that sort of constraint. So banks do - willingly and profitably - lend to service companies. In fact, it stands to reason that in many ways it would be preferable and can be proven by due diligence to be less risky than lending to asset-heavy companies which need to consume capital in order to remain operational, leaving the servicing of capital providers subordinated to stay-in-business investment.

Looking specifically at COF's creditworthiness, in the way I understand a business banker would:

First: does COF generate postive Net Receipts (NR) (ie. the cash it receives from its customers less the cash it pays to its employees and suppliers)? Answer: yes, the company has never recorded negative NR.

Second: can COF pay its tax liabilities? To measure the extent of this, I use the ratio of NR to Tax Paid. For COF this ratio has averaged 2.9 times over the past decade, which is more than adequate. The only time it was less than zero was in 2007, when working capital blew out to over 20% of revenue, but it is usually in the low teens(For fuller context, it important to note that the reason for the working capital rise was not due to COF being unable to recover receivables, but because it had accelerated payments to suppliers before the year-end balance date. So it was a reduction in payables that impacted Working Capital in that year, not an inability to manage receivables or work-in-progress.) In 2008, the normalisation in working capital resulted in NR-to-Tax Paid recovering to 4.9x, so in reality 2007's shortfall in NR should be seen in this context.

Third: having paid its tax, can COF service its interest payments, i.e., what is (NR less Tax) divided by Interest Paid? This ratio for COF has averaged a very generous 9.4x, and even during 2009 which will be a cyclical low for the company's earnings the ratio was still over 4 times. The ratio was less than parity only in 2007.

Fourth: To what extent can the company fund its internal capital requirements, measured by the amount of times Operating Cash Flow (OCF) covers capital expenditure. Again, this metric is favourable, averaging 3.9 times over time, and only less than parity following the faster-than-usual payment to creditors at the end of 2007.

So, with the exception of one year when cash flow was temporarily dampened (self-impaired), COF has been well above reproach on all measures when it comes to assuaging its lenders and creditors.

Hopefully this "capital balance" exercise demosntrates that the company certainly doesn't need assistance from an injection of new equity to service its debt; it can do so with significant ease even with a negative NTA balance sheet which in fact has no bearing on debt servicing capacity.

Attention is also drawn to a few further insights into the adequacy of the company's capital position as it stands today:

1. Of the $218m in intanglibles (Note 18 in the 2009 annual report), some $210m is goodwill that has arisen from acquisition. That the company has broken the mere $10m of down non-goodwill intangibles into discrete components reflects a desire for comprehensive disclosure, I assume, although I think the individual amounts involved (for example, Brands = $0.250m, Customer Relationships = $0.815m, and Non-compete Agreements = $0.316m) are so small as to be meaningless. But I don't think this level of disclosure can be described, as you do, as "embarrassing and pathetic". Redundant, maybe, but I don't think there's anything insiduous about it. Besides, given they amounts involved are so small, I'm confused by your questioning whether these are in need of impairment or not? It's hardly material.

As for impairment testing of goodwill, which is by far the most relevant, I'm sure you'll agree, the company uses discount rates between 15.6% and 21.2% for the discounting of future cash flows in order to arrive at the valuations of cash generating units, and hence goodwill. These discount rates, I'm sure you will agree are remarkably conservative. For further clarification on the compnay's methodology impairment testing of goodwill, refer to note 16 (b) [Key assumptions used for value-in-use calculations]. I'm sure you will rest a bit easier once you appreciate the conservativeness in some of the key assumptions that the company makes. I certainly hope it will help you correct your misguided perception that COF is "a company trying to drag every drop out of its figures in order to publish earnings to inflate or maintain its sp, is its treatment of intangibles".

2. In Dec 2008, right in the midst of the GFC, the company announced and commenced an on-market share buyback program for up to 10% of the outstanding capital. It is quite telling that at the time Net Interest Bearing Debt was at at a peak of $107m, and yet the board was still confident enough from a capital management standpoint to embark on a buyback program. And tooday (Dec 31, 2009) NIBD is even much lower @$44m. It needs acknowledging that only some $300,000 in stock was bought, but when I queried management at a subsequent meeting why the buyback stalled, they insisted that it was not due to any insecurity on the part of management in its view of the capital strenght of the company, but rather that it was down to adopting a more prudent view given the uncertainties that were unfolding in the form of the GFC.
My interaction with COF management has left me entirely convinced that management does not feel the business needs to raise new equity. I think their view would be quite the opposite, in fact. But they are, by their own admission, more cautious today than the hurly burly days of 2003 to 2007.

3. As for way the company's bankers view COF's bankability, note that COF enjoys some $220m in combined debt facilities (the bulk of which is a $180m facility specifically for acquisitions). COF had, at 30 June 2009, drawn down $166m of this, leaving headroom of some $55m. And this headroom will have expanded significantly by the time the 2010 annual report is received given Net Interest Bearing Debt had more than halved from $97m @ June 30, 2009 to $44m at the FY10 interim balance date. The facility has a four year-term, and expires only at the end of February 2012. Short-term finanical liabilities are negligible, at only $2.4m, half of which is an overdraft and the rest finance leases. So I hope this helps soothe any nervousness you might have as to the structure, timing, quantum and trends in COF's lending arrangements. The bank(s), I suggest, would be quite relaxed with the way things are travelling from a risk point of view. Their challenge, I'd strongly argue, is how to sell more loan products to a COF board that I think has become a bit too conservative and shell-shocked as a result of the GFC.


In closing, I'd like to walk you through a brief scenario in order to correct the misapprehension under which you appear to be labouring, viz.:
"This company desperately needs additional equity".

Assuming, conservatively, that:
a) COF does not experience any improvement in its underlying business performance over the next 24 months.
b) only $10m of the $12m to $15m in cost savings, that are expected in FY2011 (refer announcement of 30/06/2010), are actually realised.
c) Working Capital-to-Revenue of 12.5% going forward(noting that in the last 3 financial reporting periods Working Cap-to-Revenue was 12.5%, 11.4%, and 11.2%).
d) DPS of 3c per half for the next four half years
e) No other capital management exercises

This yields annual revenues of some $740m (compared to $772m for FY2010 [DH09,actual = $404m and JH10, expected = $368m], and $808m in FY2009).

Annual EBITDA is $48m, which converts into OCF of $31m pa, after interest and tax payments. Less $4m pa in capex and $7.5m in dividends, yields a reduction in NIBD of around $19m to $20m per year. This means that by the end of our two-year outlook period, COF's NIBD will almost halve, to $50m-odd, from $94m as at Dec 31, 2009. The interest coverage metrics at that stage will look truly luxurious: EBITDA/Net Interest would be 6.8x (currently estimated at 4.4x), NIBD would fall to 1.2x (expected to be 2.6x, annualised, in the JH10, and (NR-Tax)/Net Interest would jump to 5.6x (currently estimated at 3.4x)

So while this is admittedly a crude and simplistic modelling exercise, I think it does demonstrate quite clearly that COF's interest coverage metrics improve rapidly, even under input assumptions of quite benign business conditions and modest operating performance gains.

Absent a resumption of the acquisiton trail, COF simply has no need for additional capital. In fact, quite the opposite. If the company were to issue fresh equity today, say $20m or $30m to plug the negative NTA gap which is causing you such unnecessary worry, then it wouldn't be long before the management would be faced with questions from followers of the stock about what it was going to do with the debt-free balance sheet. You can do the simple modelling exercise for yourself to prove it to yourself. It's relatively straightforward.

Already now I can see in my mind's eye the parade of bankers preparing their pitch books in an attempt to woo COF management into procuring more of their debt products. As I've tried to demonstrate, this company has highly bankable cash flow dynamics, with solvency metrics that improve speedily over time.

If you insist on stressing about your investment in COF, then there are other far more curious things to occupy your mind, such as why the auditor was paid $1.7m last year and almost $1.0m the prior year. That's almost 10% of last year and the prior year's NPAT, respectively. What is it about the complexity of the management accounts that it requires such a costly exercise to verify them? It is the biggest niggle I have with the stock, and the very first thing I will ask when I next have the good fortune of nibbling next to management on AGM-sponsored cucumber sandwiches.

But let me repeat my view: not only is COF NOT "desperately in need of additional capital", but it is not in need of additional capital at all. In fact, in the not to distant future it will have too much of it.

Hope this helps you to relax a bit more.

Regards and Prudent Investing

Cameron

PS. Just to cover my tail (because I might find myself embarrassed by the stock going into trading halt tomorrow or next week or next month), I'm not arguing COF will never raise capital. It might. I'm just trying to substantiate why I believe there is absolutely no need for it. Save to prime the balance sheet for acquisitons.