investment treatise on cof, page-8

Persistent,

Thanks for the sanity check.

Forecasting is a flawed art (which is why so many corporate acquisitions go awry and destroy shareholder value...because they are predicated on forecasts invariably made by the biased protagonists of any corporate transaction).

And which is why I spend so much time looking at history and precedent when valuing companies.

Precedent and historical financial perofrmance give me a "feel" of the company's financial pedigree, which then puts me in a better position to "reverse engineer" the valuation problem by answering the question:

"What is the share price implying in terms for future cash flows, and how does this stand to reason with what has been achieved in the past?"

This "implicit" forecasting has the advantage of bypassing the "human factors" associated with “explicit” forecasting, which I sense is what 99% of equity market analysts do.


But back to your response to this exercise. There are three points that I believe need stressing, which I think you have failed to discern somewhat:

1. The first point is one of factual incorrectness, namely that the Net Debt is not $100m as you had stated (I'm not sure where you came to that figure...it was, in fact, about $70m at 30 June 2012, and I expect it will be below $60m at the June 2013 balance date). And the Market Cap currently is not $75m, as you allude, but $92m

2. Remember that this exercise was predicated on EBITDA remaining at depressed levels (namely at around $29m, which is 20% below FY12’s $36.8m) , and assuming no cyclical recovery whatsoever in earnings. Ever.

3. Remember, too, that this exercise excluded any re-rating of the EV, in isolation, without any attendant cyclical earnings recovery, due simply to the financial risk of the business deteriorating over time.


So, adjusting the points you raised for just factors 1 and 2 (I believe 3 will certainly occur, but let's ignore it for the sake of debate), let us now analyse the return opportunity from investing in COF under three scenarios...Unfavourable, Middle-Road and Favourable:


THE UNFAVOURABLE CASE

Under the 20% reduction in EBITDA compared to FY12 (recall, that's the scenario that results in maintaining Pre-tax Profit stable as the interest expense falls), the FCF is around $13mpa.

That equates to the extinguishing the debt by year 5, and not year 10, as you had miscalculated.

(Of course, the Market Cap starting point is higher than that used by you, so the implied compound annual return is not that much higher, at around 12%pa, compared to your 10% figure)

But the important thing to remember here is that this is predicated on what I would describe as a definitively low point in the company's cyclical earnings.


THE MIDDLE ROAD SCENARIO

To enhance the analysis, let’s assume the company’s EBITDA profile over the foreseeable future averages around FY12’s $37m.

Under this scenario, FCF is around $18m, meaning the debt disappears at around the 3.5 year mark.

Holding (again, conservatively) the EV unchanged, this translates into 17% CAGR growth in the equity value.


THE FAVOURABLE SCENARIO

Of course, should business conditions somehow become favourable sometime in the next five years, then the upside becomes accentuated.

For example, at a point half way between FY12’s $37m EBITDA and the peak EBITDA reported by the company pre-GFC (viz. $50m) the available annual return becomes closer to 25%



[AND REMEMBER, THAT NONE OF THIS TAKES INTO ACCOUNT TE SCOPE FOR A RE-RATING OF THE ENTERPRISE VALUE, AS THE COMPANY CONTINUES TO BECOME FINANCIALLY LESS RISKY.]


Of course, because they represent an inexact science, these sorts of exercises are meant to be more indicative than prescriptive, but what this one leads me to conclude is that as an investment, largely due to the dynamics of financial deleveraging, COF – at the very worst, i.e. 12% CAGR return based on Never-Again-Recovery-in-EBITDA – I am actually being paid for the option on any turnaround in the company’s earnings.


Hope this is able to clarify some of the earlier discussion.


Cam



PS. I omitted to mention that all this assessment is predicated an no working capital liberation, which is a not-inconsequential consideration.

Why this is important is because Working Cap-to-Sales is currently at record levels of 14%, having risen inexorably over the past several financial reporting periods.

To wit:

DH09: 11.2%
JH10: 12.5%
DH10: 10.5%
JH11: 13.9%
DH11: 13.9%
JH12: 14.0%

With a Revenue line of some $630m, each 1% reduction in Working-Cap to Sales, liberates around $6m in capital that can be used to pay down debt, so “normalisation” of Working Capital-to-Sales (which we know is a mantra of management (although we have seen no tangible evidence of it to date), could free up in excess of $10m of capital. That’s a not-insignificant proportion of the company’s current net debt.