The One Legged Investor

The title of this post was prompted by a good friend and fellow value investor. He recently emailed me to tell me that he was as busy as a one-legged man in an arse-kicking contest.  Well, it is reporting season on the ASX after all.

The one-legged man construct was a very clever use of vivid imagery by Charlie Munger to hammer home his message concerning the advantages of multi-disciplinary learning.  I use this imagery on myself with a slight twist- there is always something that I do not know, and hence, I am the one-legged investor in the ASX bottom picking contest. 

Readers will note that I have even changed the blog name to reflect this.

And herewith, without further ado, are my snippets from recent half year results:

CSL continues to forge ahead. R & D is now a whopping US$190m per half year. 

CBA is benefitting from Ian Narev’s focussed approach, centred on improving core competencies and customer service via use of technology.  A recent interview with the Business Spectator illuminates further Narev’s risk management approach.  My preferred bank by a country mile, but not at current prices.

CPU results were lacklustre. A big chunk of earnings contributed by margin income, which is unsustainable in the long term.

REA FY revenue estimated at $300m, and market cap is now over $3.3b yielding a market cap/sales ratio of 11.  IPP 2012 revenue is $15m and market cap is $180m yielding a market cap/sales ratio of 12.  Both still growing strongly http://www.propertyportalwatch.com/2013/02/iproperty-reports-record-traffic-in-january/

CCV reported good growth in personal finance.  Heads up TGA.

COF- three directors picking up shares.

BSA- continuing with dismal results.

FFI revenue and profits slightly down, affected by difficult trading conditions and rising costs. Full effect of property deals will not flow until 2014.  ACCC inquiry into supermarkets behaviour may improve FFI’s margins in the future.

FGE HY results- as expected. Revenue of $504m, EBITDA $62m, NPBT of $50m, NPAT $34m.  Cash on hand of $187m, order book $1.04b, and work won over last 6 months total $600m, with management providing a strong outlook for growth. Contrast this with sombre outlook from MND, which has spooked the market.  Capex $11m.  If iron ore prices continue to stabilise, projects by RIO, FMG and Roy Hill will go ahead, and FGE is the front running incumbent for these huge projects.

CLO- cash holding increased to $177m. Record order book.

SRV results held up despite difficult conditions (77% occupancy).  Operations churned out cashflow of $18m this half.  US is now cashflow neutral, with 2 floors turning mature, and 19 floors still immature. Earnings figure boosted by $3m due to artificial change in accounting treatment with the lowering of depreciation rate for leases from 15% to 10%. But the focus is clearly on cashflow.  With a market cap of $330m, and backing out cash of $100m, SRV has an EV of $230m underpinned by over $30m in operating cashflow.

FMG- Operating Cashflow barely enough to cover Interest during last half when IO price collapsed despite average realised price of US$116 per metric tonne.  There is no room for hiccups here due to the high leverage. On the bright side, FMG announced commencement of last phase of Solomon, which will benefit FGE.

IFM continues to improve under the guidance of its founder CEO. Revenue up 4% but NPAT surged 30%. A reminder that I missed this opportunity at prices under 20 cents.  SP is now over 40 cents. 

CDA has hit the ball completely out of the ballpark.  Metal detection division’s revenue of $91m for the last six months is nearly equal to one year of sales last FY.  Mining technology is also increasing strongly, albeit from a lower base. I am a bit worried about the Daniel’s acquisition. Management has upgrade guidance from $40m to $50m NPAT for this FY. I reckon this will be exceeded. Metal detection market is mind blowingly huge, even management has no idea how to quantify it.

Readers with a statistical bent will note the preponderance of shares starting with the letter C.

Forge Limited (FGE)

I recently tweeted that I am examining 3 shares which I believe are undervalued.

The third of these is Forge Limited (FGE), and I am forced to publish this earlier than expected as the company has jumped the gun on me (explanation below).

An extreme valuation sometimes makes purchase decisions very easy. The investor is given such a large margin of safety in relation to the purchase price such that not many things need to go right to get a decent return. On 5 December 2012, FGE provided this opportunity when it released an earnings update for FY13. 

FGE told the market that it expected to make Net Profit Before Tax of $90m to $100m for FY13. Give that 5 months of FY13 have already elapsed, and given that FGE stated that it expected the NPBT to be split evenly between two halves, at least $40m of NPBT has already been earned.

By way of background, FGE is an engineering and construction company providing mining services to the mining industry in Australia and Africa. As a group, mining services companies on the ASX have been deserted en masse by investors fearing the end of the commodities boom and a contraction in mining investments.

In the words of Jamie Mai, extracted from the book Hedge Fund Market Wizards by Jack Schwager, “markets tend to overdiscount the uncertainty related to identified risks.” Further, “although markets are generally good at estimating the magnitude of a contingent liability, they are often poor at evaluating outcomes probabilistically.”

It is my view that in the case of FGE, the market has overdiscounted both the rate and the magnitude of future earnings decline.

Valuation

FGE has 87 m shares on issue.  At AUD$3.85 cents, market cap is AUD$335m.  

Earnings

Earnings update on 5 December 2012- NPBT$100m. NPAT $70m. At least $40m of NPBT has already been made to date.  Backing out cash of $130m on the balance sheet (as at June 2012), this is effectively PE 3. An investor is paying about $210m for all future cashflows from FGE, bearing in mind that as at June 2012, FGE had an order book of $900m, and since June 2012, FGE has announced further contract wins totalling $360m.

A good part of FGE fortunes are tied to the actions of RIO, FMG and Roy Hill. These companies are racing against time to expand their iron ore output before iron ore prices decline further. 

Going through the financial statements, variable costs made up 60% of revenue in 2012, up from 46% in 2011. However, wage costs as a percentage of revenue have declined from 37% in 2011 to 27% in 2012.  This lower level of fixed costs provides a safety buffer in the event of a contraction in revenues.  At current prices, even if FGE's earnings declined by 50% (which is quite a distinct possibility), earnings multiple are still in the lowish single digits.

The market is pricing FGE as if it will experience an earnings decline to the vicinity of $20m per annum.  This is not impossible, but for what it is worth, I believe that the chances of this happening in the next 5 years is quite remote. The more likely scenario is that within the next 5 years, total free cashflow from FGE will exceed the share price being paid today.

Disclosure: The author owns shares in FGE.

Disclaimer: the content of this post is not to be relied on as financial advice.  It contains my personal opinion only, plus facts that I cannot verify to be accurate.  Do your own research and seek financial advice where appropriate. I have made many mistakes in the past, and will continue to do so in the future.