Metrofile – Why I expect earnings to grow and the dividend to shrink temporarily

metrofile

Metrofile is a business directly in my sweet spot. It is boring, it is ready to grow in Africa, it carries an attractive valuation, generates buckets of cash and pays a healthy dividend. In keeping with their boring nature, MFL recently produced decidedly unspectacular results for the 6 months to December 2017. Earnings were pretty much flat after adjusting for the once-off profit from the sale of a small subsidiary. They earned 15.6c/share for the period. After reading through the results, I have come to the conclusion that their earnings are likely to increase in the second quarter for the following reasons:

  • The expended R45m on expansion capital. Assuming that these projects were justified on an IRR of at least 10%, this should add about R4.5m to annual earnings or about 0.5c for the next 6 months.
  • Despite tough political conditions in Qatar, they grew revenue from Africa and the Middle East. When Qatar turns around, which it is already showing signs of doing, this will continue to grow earnings from this area. Let’s give it a 10% growth from that area or 0.3c.
  • They bought Secure Data Solutions (SDS) in Kenya for approximately R280m, with an annual EBTDA contribution of approximately R28m. This is a pleasing acquisition, as it grows their footprint onto Africa, where much growth for this business is likely to come from, given the constraints imposed by bureaucracy across the continent, coupled with a very positive outlook for Africa in the medium term. Importantly though, the deal will be earnings enhancing from the outset. Assuming a cost of debt of 8% for Metrofile, this deal should contribute approximately R6m to earnings, which is equal to 1.5c per share per year, or 0.7c for the next 6 months.
  • Metrofile shares are trading at bargain prices. Chairman Chris Seabrook showed what he thought of the value, when he recently purchased R52m worth if shares at R3.50/share. The business is also taking this opportunity to buy back shares, something that undervalued South African businesses do not do enough. In the first 6 months of the year, they bought back 5m shares at R3.99/share. This means that they bought back 1.2% of the company. All other things being equal, this alone should result in an increase in earnings of 1.2%, which is equal to 0.1c/share for the next six months.
  • Management writes the following in the results. “Metrofile remains well placed in the forefront of an industry that is evolving rather than shrinking. Metrofile anticipates a stronger second half earnings.” I love it when companies I own are that positive about the future of their business. I will give them an extra 0.5c/share for the optimism.

These factors add up to growth in earnings for the second half of 2.1c, total earnings of 17.7c, putting the share on forward earnings of 35.2c or a PE of 10.

Whilst this is excellent news, I also think the dividend will reduce slightly. The group previously announced that they would increase dividends until they had reached targeted debt levels of at least 1.5 times EBITDA. With the recent acquisitions and expansion capex, debt is at approximately 2.5 times EBITDA, indicating that management has more than achieved its debt targets. This, in turn, means that we can expect dividend cover to revert back to the historical level of 1.5. I therefore expect dividends to be about 11-12c for the second half, putting Metrofile on a forward yield of 6-7%.

L4L – Do I stay long in Long for Life?

Long for Life (L4L) recently announced their intention to acquire the entire outstanding shares of Holdsport (HSP). HSP was trading at around R57-R60/share prior to the announcement of the deal and L4L’s revised offer is 12.1 L4L shares for each HSP share. At the current L4L price of approximately R6.20-6.50/share and assuming the acquisition gets all required approvals, HSP shareholders stand to make approximately R75/share – a juicy 25% premium. As I hold some HSP in my portfolio, I am pleased with the premium, but I am now faced with the dilemma of whether to continue holding the shares in L4L or whether to sell them and re-invest the money elsewhere.

What is L4L?

Long for Life is a listed investment vehicle started by industrialist and capital allocator extraordinaire, Brian Joffe. After his retirement from Bidvest, this company is Joffe’s retirement project. L4L listed in March this year at healthy premium to cash with no assets and has since inked three transactions. If all three of these are successfully concluded, the company will consist approximately of the following:

A market cap of approximately R5bn comprised of

  1. R360m invested in bottling and plastics business Inhle (net tangible asset value of R53m)
  2. R116m invested in beauty retailer Sorbet (net tangible assets R5m)
  3. R3,200m invested in Holdsport (net tangible assets R900m)
  4. R1,500m in cash

The Pros

  • Capital allocation: Kevin Hedderwick and Brian Joffe have both built up large fortunes and have healthily rewarded shareholders in their previous companies. These men should have the ability and capacity to recognise value and establish synergies.
  • Good deal: I owned HSP, because they are a good company, at a great price in a sector that is likely to grow significantly in the coming decades. Clearly the L4L capital allocators see the same value and they are investing in a company that is very cash generative and provides a scalable platform for synergies.

The Cons

  • Dividends: One of the main reasons that I owned HSP was the healthy dividend, with a yield of over 5%. L4L is unlikely to pay a dividend, therefore reducing the cash flow from my portfolio.
  • Fees/incentives: Typically, equity holding companies of this type richly reward management with % fees based on assets managed (think Zeder or Reinet). Fortunately, L4L does not follow the same greedy structure. Nevertheless, management is extremely well paid for essentially a portfolio management role and directors all got in at R4/share prior to the listing. Lucrative share bonuses are awarded based on growth rates in share price, which is a reasonable compensation for this type of business, but depends on where you draw the line in the sand. In summary, whilst remuneration is high, it is better than many other companies and not out of line.
  • Overpaying: All three of the first deals are significant overpayments in terms of tangible asset values, introducing a healthy amount of goodwill into the books. Synergies at this stage are also not clear. Particularly the Sorbet and Inhle deals appear to be richly priced, when compared to market peers and the current SA consumer environment.

In conclusion

L4L’s management team have proven that they can create value. They are assembling a portfolio of assets in a period where the consumer is stretched, which should ensure that they are buying these companies at reasonable prices and preparing for an inevitable upturn in sentiment in the future. However, given the current environment, L4L appears to be paying relatively high prices for these acquisitions and they are using over-priced shares that are trading at significant premium to cash and tangible assets for these deals.

For this reason, I will sell my shares in L4L after the conclusion of the HSP transaction, as I expect the share price to trend towards NAV in the future.

SSK – Too cheap to ignore

construction

Construction is a difficult business. It is essentially commoditised, that is we do not really care, who builds something for us, as long as they build it cheaply. Therefore, margins tend to be thin, costs need to be controlled, staff turnover is high, safety is a constant challenge, the business is labour intensive and requires large amounts of working capital. In addition, the industry is highly cyclical and is yet to emerge from the last trough, the post-Football World Cup hang-over. This is not an industry that I would typically invest in.

Diversified construction major Stefanutti Stocks Holdings (SSK) is in the middle of this challenging industry, in a South African market that is reluctant to invest in a political environment that remains unconducive to investment. The company, is well diversified into all facets of the industry, with operations in marine, civil, structural, mechanical, steel, buildings, mining, petroleum in South Africa, Southern Africa and the Middle East.

From the latest annual results, it is evident that times are tough: revenue is down 8%, margins are contracting and they make reference to overall cost deflation in the industry. The financials are marred by impairments for businesses that were acquired during the boom time, fines from the competition commission and forex losses resulting from a strengthening Rand.

However, when we ignore the perfect storm that has hammered current results, when we start digging through all the once off items, we start to come across several metrics that show a healthy, if not flourishing, company that is trading at fantastic bargain prices:

  • This is a huge company. They did R10bn in revenues last year. This tends to be forgotten at the current market cap of only R630m.
  • If we adjusted some of the once-off items in the earnings, we get a company that is trading at a PE of 4.
  • They have a pile of cash at R1.1bn. Yes, that is about 1.7 times their market cap in cash. In fact, the business remains VERY cash generative. They have operating cash flow of almost R400m. The means it’s trading at less than two times cash flow.
  • They are trading at 43% of their current TNAV. Yes tangible NAV. In theory they should be able to liquidate their assets, pay off their debt and then pay almost two times the value of the business as a special dividend. But, why would they do that, if they are making so much additional cash each year?
  • They have an order book that means that even at current margin, cash flow can be maintained. It stands at about 1.4 times annual revenue. About 30% of work is outside RSA and this is likely to grow, as those economies mature and make the best of their demographic and resource advantages.

In summary, this is a company that hiring and growing into Africa, that is generating healthy cash flows and that stands to benefit from the pent up demand for infrastructure in Africa. The company is also extremely cheap and I am therefore doubling down my position in the business.

TAS – Digesting the Press Release

Taste

Taste Holdings (TAS) is a frightfully frustrating company. They have some great brands and are positioned in a market with excellent long term growth prospects, particularly in sub-Saharan Africa. Yet management are frustratingly cryptic in their press releases, often lack transparency and have the little investor wondering, whose interests management really has at heart. I previously wrote about their suspicious acquisition of loss-making franchise stores from their own management team. The 4 April press release entitled “Taste – group to focus on food in the future” appears to be another master piece of suspicious information.  Let us slowly, piece meal digest this press release:

 

  1. They are intending to sell their jewelry division.

 

This seems like a smart move. As they explain, the two businesses require different levels of focus. The jewellery business is likely to have little growth, high margins, good cash flows and requires a good degree of gearing. In other words, it is a cash cow, that requires a specific type of management. The focus is on high income consumers, on operating costs and requires limited innovation.

 

The food business is in a growth phase, requires entrepreneurial thinking, expansion and is hamstrung by debt. The focus is on lower income consumers, on expansion and on achieving scale.

 

Jewelry and franchise fast food were always a strange combination of businesses, but they are also at different stages of the business cycle and require a very different approach from management. I have previously written on the strong fundamentals that support increased dining out in the future and I support this renewed focus on the food business. A focus on lower income consumers is also more appropriate for a business looking to expand rapidly in southern Africa.

 

  1. They have not disclosed a price yet

Whilst I fully support the intention to sell the jewelry division, they have not disclosed the intended selling price. In the last Annual Report (Feb 2016), the division produced roughly half of the group’s revenues at R570m, an EBITDA of R70m and a pre-tax Profit of R43m. The division had assets of R416m and liabilities of R212m.

It is difficult to value this division, but, as it generates half the revenue, as a starting point, it could be considered worth half the TAS market cap, i.e. R390m. That would put it on 9 times pre-tax profit, or 0.7 revenue. Another good reference is when TAS bought Arthur Kaplan for R85m in cash in late 2014, that was on a multiple of 0.4 revenue and 5 times pre-tax profit. By those metrics, the jewelry division should be worth approximately R220m.

  1. They are offering shares to existing shareholder to reduce debt

Existing shareholders are being offered 80m shares at R1.50/share, putting R120m in the kitty to “reduce debt”. On the last interim balance sheet, TAS had R480m in debt. R210m of this is within the jewelry division and would presumably be sold together with the business, which leaves a net debt of R270m. If the clawback adds R150m, is the jewellery division only worth R120m? Or where is the other R100m going?

80m shares is an effective dilution of 20%. In my opinion there appears to be little justification to dilute shareholders by one fifth, to pay down debt, that should be covered by the sale of the jewelry division alone.

  1. They have a big daddy shareholder(s) – who doesn’t want to buy the whole company

Finally and most interestingly we learn once again about a consortium controlled by Protea Asset Management and Conduit Capital, which in May 2016 acquired 31.4% from Brimstone and other investors. This consortium now controls around 35% and is likely to go above this with the subscription to the claw back offer underwriting of the rights issue. Importantly, they have asked for exemption from being forced to make an offer for the entire company when they exceed this threshold.

Let’s add in management’s stake at 17% and somebody called Khrom Investment, who announced a 5.2% stake on 6 April 2017 without further explanation and we have 57% of the company tightly held. I like strong supportive shareholders, who believe in the business and see value at current prices – with TAS I just wonder whether other minorities are having their interests protected.

So how do I feel about the events described in the announcement? I like the focus on food, I like the elimination of debt, I like the big shareholders pushing through their vision and clearly seeing value in the food business. I don’t like the lack of transparency in the press release, I hate the implied lack of value of the jewelry division and, after previous corporate activity, I have trouble trusting management.

The big test for this company will be to see to whom and at what price they are selling the jewelry division. If it gets sold to an independent party for R200m-R250m, then tuck into the new owner’s and strategy, if it gets sold for R100m to an undisclosed buyer or some shady offshore fund, then run for the hills.

MDI – A ridiculousy low PEG ratio

The rumour has it that when Danie Pretorius bought his first second hand raise bore rig in 1986, he was fixing it up at his home, but, as it was too large for his yard, it was protruding out onto the street of his Fochville suburb. 30 years later, Danie owns 53% of a R2.5bn company and Masterdrilling (MDI) is set to continue growing for years to come.

The company now owns 105 raiseboring rigs and is expanding into conventional exploration drilling as well as blind boring. Their fleet of raiseboring rigs is the largest in the world and their expertise and innovation in this niche industry is second to none.

In their recently announced results for the year 2016, MDI declared profits of R2.10/share and a maiden dividend of 30c. This puts the share on a Price Earnings multiple of 8.5 and a dividend yield of 1.7%. Most importantly though, earnings grew by 20%, after growing 30% in the September 2016 half yearly results and 31% in the 2015 financial year. As is often the case for these rapidly growing companies, we analysts can apply a PEG ratio, by dividing the PE multiple by the company’s growth. Generally, anything under 1 is considered excellent. For instance a company that is growing at 20% should trade at a PE of 20 (like Google parent Alphabet). MDI’s PEG of 0.43 is ridiculously cheap.

A more careful inspection of earnings, however, reveals that all of last year’s growth was derived from exchange rate benefits, against the backdrop of a difficult mining industry environment, the company actually stagnated in dollar terms. I work in the mining industry and the market is definitely showing signs of turning. MDI are brilliantly positioned for this increase in mining capex with their truly global presence. They have just established footprints in DRC, Tanzania and Sierra Leone to supplement their African platform in established mining jurisdiction such as Zambia and South Africa. When this is coupled with a strong presence in South America in the mining hubs of Brazil, Chile and Bolivia, an ongoing contract in the USA and a shareholding in Swedish Bergteamet Raiseboring Europe AB, it becomes clear just how well this company is positioned for the next upturn in the market.

With a cost base that is mostly in Rand, they should remain globally competitive and continue growing for years to come.

The use and application of the raiseboring and blindboring technologies is growing strongly. They are non-explosive excavation methods that are safer and cheaper than conventional drill & blast mining. Increasingly, their use is also growing outside of mining into infrastructure projects, such hydropower plants, tunnelling and storage.

Due to MDI’s unique global position in this growing niche market, it is difficult to compare it to a peer group. Redpath, is the world’s largest shaft sinking company. It is privately held by a German family holding company, ATM Holding, the same company that recently took a 25% stake in South Africa’s other shaft sinking champion, Murray & Roberts. Redpath is rumoured to be valued at $1.1bn, while M&R carries a valuation of R7.5bn, approximately 3 times the value of MDI.

Given MDI’s competitive advantages and growth profile, it may not be too far-fetched, to consider that this company could one day be the size of Murray & Roberts. They are managed by a driven individual, who has a large vested interest in the future performance of the business and continue to operate in a growing niche. If the mining industry turns upwards in the next few years, and the MDI multiple expands as the company continues to deliver, I am convinced that this company can easily increase in price by 2-3 times from the current level. MDI remains incredibly cheap.

ILU – A much better way to buy-to-let

Many affluent South Africans are firm believers in owning additional properties, which they rent out to tenants, the buy-to-let strategy. This is a solid strategy, which offers good long term returns at low risk, an understandable business model and has made a few people very wealthy.

I myself own a two-bedroom property in Centurion, which I purchased for R 640,000 two years ago. The monthly rent is R6200, but after I have deducted rates, taxes, agent’s fees and levies, I am left with R3700, an annual return of 6.9%. That is if the tenant pays, no repairs are required or any other unforeseen events occur.

Indluplace Properties (ILU) is a listed REIT (real estate investment trust) that owns 5,500 apartments and manages them on the shareholder’s behalf. Their properties are worth R2.3bn and they have 97% occupancy. At this scale their risk is diversified and maintenance is centralised. ILU paid a dividend of 93c in the last year, putting them on a yield of 8.9%, a full two percentage points higher than my buy-to-let property.

“But, Mr Business Musings”, you may argue, “you do not understand the purpose of buy-to-let! Have you considered: “

  • “My property is in a fantastic location and is sure to go up in value.”

ILU own bachelor, one and two bedroom apartments, which are 90% in Gauteng, particularly in the revitalising inner cities. I have previously explained how demographics are almost certain to positively affect property prices in this province. If the value of ILU’s properties goes up, so will the share price and the yield. If my view of the fundamentals of the property market changes, then I can sell my shares within a day. If I wanted to sell my property in Centurion, that would be a far more difficult and expensive undertaking.

  • “My rent goes up every year, my bond costs stay the same”

As rents go up, so will the funds that ILU has available for distribution. The costs of debt change for both you and ILU in line with interest rates. Although, it is likely the ILU – as a billion rand company – will get better interest rates than you.

  • “You are ignoring taxes in your assessment!”

Taxes are the same for rental income and dividends paid by REIT’s. Both are taxed at your marginal tax rate. You can offset your interest rate on your bond and your property expenses, but ILU is doing the same, before they pay out their remaining cash flow in dividends.

  • “You are forgetting the benefits of gearing!”

Indeed, this is the only good argument I have heard for buying your own rental property. A deposit of R100k means that if the property increases in value from R600k to R700k, you have doubled your investment. ILU is mostly ungeared, their debt is only 10% of assets. However, I do not regard this as a negative. I believe this offers them room for massive growth in shareholder returns. As their debt-to-equity ratio is increased, they will more closely approach this last benefit offered by buying your own property.

In fact, I am convinced that management is keeping their debt low in preparation for a juicy acquisition at current low property prices. In the forecast of the previous annual report:

“The board is confident that ample opportunities for acquisitions exists and that Indluplace will grow the portfolio substantially over the next few years notwithstanding the current financial climate”

It is therefore not surprising that they are currently trading under a cautionary announcement, pending the announcement of a transaction.

I never tire of taking joy from directors holding shares in the company, in this case 7.3%. Cornerstone and founding investor Arrowhead Properties hold 60% and are likely to provide strategic guidance and direction for the moment.

 

CIL – The good, the bad and the ugly

power-lines-504

The good

Electrification in Africa is a huge theme. The bulk of households in sub-Sahara Africa do not have access to electricity and, where it is available, it is poorly distributed and maintained or fluctuates wildly. More and more, these people will  demand access to electricity, as the ubiquitous availability of cellular phones has made them increasingly aware of the quality of living improvements that it can offer. At the same time, access will become more viable through the increasing development of Africa, the consumers’ rising purchasing power and the continuing decrease in the cost of renewable energy providing a viable alternative to more standard large scale technologies.

All of these trends play into the hands of the companies, who build and maintain the infrastructure that is required to distribute this electricity. Consolidated Infrastructure Group (CIL) has grown phenomenally over the last few years, as they have complimented their position as a market leader in South Africa with a large and growing business in a plethora of African countries. They are positioned for the growth that is certain to come in Africa and have increased their cash flow from operations at home by diversifying into the smart metering market through the acquisition of Conlog.

The company has strongly growing revenue, and EBITDA and a ballooning order book. With their latest earnings, CIL is trading on an approximate PE of 9. Furthermore, directors and associates hold 9% of the company, showing a vested interest from management in the long term performance of the business.

The bad

It may sound petty, but it always raises an internal warning signal, when a company does not make their financial results easily available. Rather than most other companies, CIL did not publish their results on SENS, rather they informed investors that they are available on the website. When attempting to find the results on the website, the link to the 2016 results pops out the 2015 result pdf file. Finally, after some search, I found the 2016 annual report.

Ohhh and also the company did not declare a dividend.

The ugly

A look at the financial results shows a possible explanation why the financials are so difficult to find and also why the company does not pay a dividend.

In the last year “amounts due from contract customers” increased by R1bn to a total of R3.7bn. To put that into perspective, the increase in receivables is more than the entire gross profit of the company in the last year, putting a severe strain on cash flow. These appear to be owed by various  sources and from various contracts. The company is trying to offset this by delaying their own ayables, but this will not be a sustainable solution.

R3.7bn is more than half the assets of the company. It is also more than the entire NAV of the company. R25/share in “amounts due from contract customers”, more than the current share price.

Of course, delayed contract payments of this nature and working capital management are part of operating in the construction industry, but increases of this size and exposure of this severity should warrant a few explanations from management. Unfortunately, none can be found in the annual report.

Conclusion

Due to this large exposure and increase in receivables, I am no longer comfortable being a shareholder in this business and have sold my shares. However, I remain very optimistic about the long term future of the electricity sector in Africa and am using ARB Holdings as my exposure into this theme.