investment thesis

ORGANIC EARNINGS GROWTH

After doubling in FY12, EPS for SKE is expected to grow by double-digits for the foreseeable future.
What I particularly like about this prospective growth profile is that it is all internally derived and within the control of the company’s management team, as opposed to being at the mercy and/or whim of some or other fortuitous externality(ies).

Consensus forecasts are saying EBITDA for the current half of FY12 will be around $46.5m, which is 3% higher than the $45m made in the Dec half, and about 10% higher than previous corresponding period. This is despite confirmation from the company that they have locked in $12m of cost reductions over the past 12 months, and that the current half had started reasonably well.

The depreciable and amortisable asset base is clearly falling, and therefore so will the D&A charges:
Going forward, Capex and Acquisition of Intangibles are collectively budgeted to be running at $10mpa, including the investment in business process improvements and automation
(invoicing, employee recruitment and time sheet management in particular). This level of investment is only 75% of current D&A levels. Also, PP&E at 31 December 2011 was $10.6m (down from $16.8m at the December 2010 balance date and $13.3m at the June 2011 balance date), and non-goodwill intangibles was $53m (down from $64m in December 2010 and $56m in June 2011), of which $14m is indefinite intangibles relating to the SKILLED trademark and brand name, and does therefore not get amortised.

Also, interest expense will fall for reasons other than just lower levels of borrowings:
In SKE's most recent few results, about one-third of the total interest expense was shown to be due to amortisation of loan establishment fees (which are non-recurring, going forward), and interest rate hedge costs (rolling off over the next 12 months). Consensus FY13 interest expense forecasts are about the same as the annualised figure implicitly being forecast for the current half, which cannot be right given the elimination of these aforementioned costs as well as lower levels of borrowings and lower rates.


LOW CAPITAL INTENSITY AND STRONG FREE CASH FLOW GENERATION

SKE is an asset-light company.
Operating Cash Flow has exceeded Capex plus Acquisition of Intangibles 17 times out of the past 20 financial reports.
On average over the past decade, the ratio of OCF to Capex plus Acquisition of Intangibles has been a high 7.9x, and since the appointment two years ago of the current CEO, it is averaging 10x.
Capex plus Acquisition of Intangibles as a proportion of EBITDA, has averaged only 15%, and since the GFC it has been less than 9%. The outworking of this is that overwhelmingly the bulk of EBITDA is freed up to service after-tax returns to capital providers.
As a result, EBIT on Net Tangible Asset is currently 23% and has averaged 17% over the past decade. It has never not been in double-digits, even during the GFC when it bottomed at 11%.
SKE is also not a working-capital demanding business, with Working Capital-to-Revenue averaging around 7% over the past decade.


ON THE BRINK OF ACCELERATING CAPITAL RETURNS

In a low-growth, low-interest rate environment, which is what we unequivocally have on our hands today, dividend yield becomes significantly re-rated by market participants.
This starts with the most visible yield offers, such as CCL, GNC, IAG, SUN, TAH, TLS, TCL, WES and bank stocks, all of which at the beginning of the year presented gross dividend yields close to, or above, 8%, after adjusting for franking credits.
Trouble is, because these attractive yields are readily observable and self-evident, the stocks soon become fully valued, as has been the case for almost all of these stocks over the past 12 months, as they have all outperformed the broader market by far.

The appeal of SKE is that, while its prima facie DY is about 4.5% presently, this ignores the PROSPECTIVE dividend yield.

This argument is driven by the rapid deleveraging of the balance sheet currently underway:
NIBD/EBITDA for the DH2011 was 0.8 times. This is the lowest it has been for the past five years, and looks set to fall dramatically over the next two years to zero by June 2014, assuming:
- 50% Dividend Payout ratio
- 7.5% Working Capital-to-Sales
- 6%pa EBITDA growth
- Settlement of deferred acquisition payments ($15.5m in total) within the next 18 months
- No further acquisitions (other than Intangibles) being made

For context, the company’s NIBD-to-EBITDA history, along with my modelled NIBD/EBITDA forecasts are as follows:
DH02: 0.7
JH03: 0.5
DH03: 0.8
JH04: 1.5
DH04: 1.2
JH05: 0.7
DH05: 0.2
JH06: 0.9
DH06 2.9
JH07: 2.2
DH07: 3.3
JH08: 2.3
DH08: 2.6
JH09: 4.4
DH09: 2.9
JH10: 2.5
DH10: 2.3
JH11: 1.1
DH11: 0.8
JH12 (f): 0.7
DH12 (f): 0.5
JH13 (f): 0.4
DH13 (f): 0.2
JH14 (f): 0.1

The projections of the company becoming virtually debt free within the next 2 years (from NIBD of $71.7m at the December 2011 balance date) is derived from:

Cumulative Operating Cash Flows (including JH12) of $170m
Less: Cumulative Capex of $15m
Less: Cumulative Acquisition of Intangibles of $10m
Less: Payments of Deferred Acquisitions of $15.5m
Less: Cumulative Dividend Payments of $67m

Viewed another way, under these assumptions, EBITDA-to-Net Interest will rise from an already comfortable 8.6x (DH21) to 15x in the JH3 and a ridiculous 29x by JH14

While this is clearly a theoretical exercise, and while GFC-type levels of balance sheet stress will never again be countenanced under the current management, I do believe that double-digit interest coverage ratios – we are there today - will be the catalyst for accelerating capital returns to shareholders, most probably in the form of increased payout ratios, but possibly in the repurchasing of G. Hargraves residual holding of 30.2m shares. My modelling suggest that a buyback of the Hargraves stock would be 4% to 5% EPS accretive.

The cash generating prowess of this business is such that even if the Hargraves’ holding was acquired in the current half year at the current share price (in reality it would be done at a discount to market), NIBD/EBITDA would rise to 1.2x, which would be perfectly manageable given that it would fall back to 0.8x and EBITDA-Interest coverage would be back at double-digits within 18 months.

Alternatively, even if the Dividend Payout Ratio was lifted to 100%, NIBD/EBITDA would remain static, at around 0.5x, and EBITDA-to-Net Interest would end up in the high teens.
This would equate to a 10%, fully franked Dividend Yield


IN SUMMARY

SKE is not a stock for speculators looking for a “multi-bagger” crapshoot-type punt.

Instead, it is a low-risk, dependable vehicle for wealth creation with a granular revenue stream, a disciplined and astute management team, limited calls on capital compared to its cash generating abilities and with internally-generated, organic earnings growth.

At FY13 valuation metrics of 6x EV/EBITDA, 10x P/E and 9% Free Cash Flow Yield on an Enterprise Value basis, this presents an undervalued proposition given a bankable EPS growth opportunity of 10% to 15%pa over the foreseeable future.

On a Risk-Reward basis, SKE is one of my highest-ranked investment opportunities right now.