investment treatise on cof

I sense there is a lot of debate as to the merits – or otherwise – of an investment in COF, so I thought I might add my sixpence worth of opinion, especially given this has been one of my less stellar performers over the past 6 months, with the share price remaining essentially unchanged over the past 12 months following the repair of the balance sheet in Nov 2011 via a $40m issuance of new equity @ 38c/share.

My view is that – as an investment security - the company is misunderstood today. My contention is that this is because of some unique quirks in the P&L, which are legacy issues arising from the way the company was strategically managed in the late 2000s.

My central thesis is that whereas analysts and most retail investors have their focus on after-tax earnings, the real trick to understanding COF is predominantly as a cash flow story.

Usually, After-Tax Profit and Free Cash Flow have some relationship, but in COF’s case they tell somewhat opposing stories, the former a negative one and the latter a resoundingly more positive one.

To explain this requires taking a longer-term historical perspective than hysteria - induced by recency biases - permits.

It is instructive to view COF through an imaginary tri-focal lens (if one can envisage such a thing): one part that sees the company Pre-GFC; the second one, During the GFC; and the third one, Post-GFC


To wit, the Coffey story follows:

1. The Five Years Leading up to GFC (2005 to 2009):

The then-COF board and management – emboldened by the economic boom wherever they looked – went on the mother of all investment and acquisition sprees.

They spent a whopping $180m in the five years to June 2009, $36m on capital projects and, alarmingly, $147m on acquisitions.

Given that:
a) at the start of this period, COF’s EBITDA was already tracking at about $15m pa, and
b) the current Enterprise Value of the company is just $145m,

it follows that a significant amount of shareholder value was destroyed in the process.
Either that, or COF is today grossly undervalued.

This exercise will conclude that the answer lies somewhere in the middle of these two hypotheses.

It is important to understand the toll this aggressive growth strategy has placed on the company, the effects that are still being felt to this day, but which have largely been addressed.

Specifically, to fund this $180m of spending, COF increased net borrowings by about $100m and raised equity funding of $80m.

It warrants mentioning that COF over this period generated some $75m in cumulative Operating Cash Flow of which $63m was distributed to shareholders by way of dividends.

In the context of a market capitalisation today of around $90m, those cash flows are highly material, by any account.

The GFC hit when COF had $100m of Net Interest Bearing Debt, supported then by $50m pa in EBITDA.

It turned out to be too much.


2. The GFC Years (2009 to 2011):

The aftermath of the GFC proved challenging for COF, with the double whammy of lower EBITDA and higher interest costs, causing OCF to deteriorate dramatically.

In FY09, EBITDA was $51m. In FY10 it fell to $47m, and in FY11 to $31m.

The interest bill, on the other hand, went sharply the other way: from $8m in FY08 to $11m in FY10 and a crippling $19m in FY11.

As a result, OCF in FY09 was $30m, in FY10 it dropped to $15m, and in FY11 it went negative, for the first time in the company’s contemporary history, at minus $5m.

It was then that the board fell on its sword, sacked several senior executives and started to repair the balance sheet.

With Net Debt at $124m, EBITDA at $30m, the renewed board and executive team raised $40m of new equity and locked away the company cheque books.

And the healing process began in earnest.


3. Today (2012 and forward):

Despite NIBD falling from a peak of $124m to the sub-$60m I expect we will see for the December 2012 balance date (it was $70m @ 30 June 2012), COF’s financial statements still bear the hallmark of those cavalier years.

Specifically, EBITDA to Net Interest Coverage for FY12 was 1.9 times (well down from historical average levels closer to the more acceptable 4 times, albeit up on FY12’s 1.3 times).

Related to this – and this the most important point to be made in this missive – the interest bill is a highly significant feature of COF’s P&L today, representing a whopping 115% of Pre-Tax Profits.

Put another way: AS THE DEBT DISAPPEARS, THE BOTTOM-LINE EXPANDS VERY DRAMATICALLY

Specifically, once the debt is payed down, even without any improvement in the operating performance of the business, PRE-TAX PROFITS WILL MORE THAN DOUBLE
[It’s also known as financial deleveraging]

For example, in FY13, I expect the interest expense will be around $7m (due to the combination of lower debt levels and borrowing costs), compared to $14.8m in FY12 ($9.4m in first half, $5.4m in second half)

This means that EBITDA will be able to fall by almost 25% compared to FY12’s $36.8m, and COF’s Pre-Tax Profit line will remain unchanged.

For what it’s worth – and I don’t believe it’s worth very much at all:

- if EBITDA does fall 25% in FY13 (and I don’t believe it will) this would put the stock on a P/E multiple of 10x and an EV/EBITDA multiple of 5.2x
- if EBITDA is held at that same levels as FY12 then the stock is valued at 6.1x P/E and 4.0x EV/EBITDA (In this case Pre-Tax Profits would rise by two-thirds, to around $21.5m, compared to FY12’s $12.9m....such is the power of a rapidly deleveraging P&L)

I suspect somewhere in between the above two outcomes will be the likely outcome.


All this ruminating about P&L deleveraging leads me to believe quite firmly that operating performance – per se – will not be the driver of Coffey’s share price performance going forward.

Rather, Free Cash Flow and the paying down of debt will be the more significant driver of earnings.

Hence(and forgive me, I know it’s been a long-winded journey to get here) it is the Free Cash Flow attributes of the company that matter most.


So let’s look at Free Cash Flow:

Over the past eight years, COF generated total FCF of some $50m.

However, excluding the burden of interest costs, the total FCF is a whopping $120m.
This is highly material in the context of a $90m Market Cap and even in the context of a $150m Enterprise Value.

As a determinant of valuation, I think it is the most valuable measure:

So, on a FCF yield, I estimate COF is trading at somewhere around 15% based on its Market Capitalisation, and 12% on an EV basis.

Either way, it remains attractively valued and as long as the current board and management see their KPI to continue to reduce the debt (and they don’t seek to acquire anything, which I firmly believe they won’t) then I fully expect that the Enterprise Value will remain unchanged going forward – at worst – and the Equity Value will rise to vacate the space left by the disappearing debt.


Bit of a long story for a small stock


Cam