HGG hhgregg Analysis

Current price: $12.29
Market cap: $473.4m

P/E: 10.3
P/B: 1.5
P/S: 0.2
P/CF: 8.4

hhgregg (HGG) is a small-cap retailer of consumer electronics and home appliances. The company caught my eye because the stock has been beaten down almost 50% from the 52-week high and sold at a surprisingly low P/E for its earnings and sales growth.

It has an interesting recent corporate history. The company was recapitalized in 2005 (hence the jump in total debt) and then IPO-ed in 2007 (hence the sudden reduction in debt). Growth in store count was relatively slow until the IPO, with only 4-10 new stores opening per year. After the IPO store openings increased ever year, totaling 42 net openings in 2011.

To get a sense of how this has affected the company, I built this sheet of its performance over the past decade to take a look at its performance over time:

A few things stand out. As others have pointed out, part of the recent decline in ROE comes from the steady decrease in leverage. It also comes from a slight decline in ROA which you can also see reflected in the downward trend in sales and earnings per store. Returns on invested capital remain strong, however, and actually inched upward in FY 2011 due to the reduction in debt.

Returns per store are also surprisingly high in spite of the decline in per store profitability. Capex for 2011 was about $60m and HGG opened 42 stores, so figure a rough cost per store of $1.43m. If their stores continue to earn around $0.28m per year, that’s a 19.6% return on their invested capital for newly opened stores – definitely better than you would expect given the its current valuation and 50% decline from the 52-week high.

A less impressive figure is its record of earnings growth. Over the past 10 years, earnings have increased 64%. That’s a compound growth rate of 5.1%. Store count, on the other hand, grew four-fold from 42 to 173. This comparison is somewhat skewed because HGG was an S-corp in 2002 and distributed its earnings directly to owners for whom it was taxed as income and therefore it incurred no corporate income taxes. Adjusting for taxes using the 2011 tax rate, 2002 income was $18.8m and ten-year earnings growth improves to 156%. That’s a little under 10% per year against annual store growth of 15%. Earnings growth still lags but the shortfall is much smaller.

With that in mind, growth is a mixed bag for HGG. The general decline in same-store sales means that a moderate amount of growth is required just to maintain earnings and that growth will continuously become less efficient as long as the trend continues. It also means that HGG’s substantial expansion has proved less profitable than management might have hoped. On the other hand, growth is now relatively safe for HGG. The company was able to fund its capital expenditures out of operating cash flow in FY2011 and should be able to do the same in 2012. There’s no need to issue debt – in fact, the company just paid down the last of its debt – or dilute existing shareholders (they’re actually planning to buy back shares). There’s also not much financial risk now that HGG finished clearing out all its long-term debt. This makes it a lot more comfortable risk-wise to wait patiently for conditions to improve.

2011 annual report

I now have a site at http://www.dollarwisefl.com and I’m gradually shifting my work there, so I’ll probably only post a few more articles here…

Posted in Analysis | Tagged | Leave a comment

HITK Hi-Tech Pharmacal Analysis

Current price: $30.09
Market cap: $383M
P/E: 9.43 with losses from discontinued operations; 8.95 from continuing operations
P/B: 2.12
P/FCF: 15.46
EV/FCF: 13.47

Hi-Tech Pharmacal is a manufacturer of generic, branded over-the-counter, and prescription medicines. The company concentrates its efforts on liquid and spray products. The company experienced two years of stagnating sales and losses in 2007 and 2008 before returning to profitability in 2009 and seeing sales surge in 2010/2011 on the strength of its generic Flonase/Flovent product.

The relative valuation seems extremely appealing, perhaps due muted analyst projections for the coming year. According to data available on Reuters, even the most optimistic of the three analysts covering HITK expects 2012 sales and earnings to be below 2011 levels. Analysts are probably concerned because the FDA has stopped the sale of Lodrane, a cold/flu medicine that is the primary product of HITK’s branded prescription medicine division. I think that those projections are too pessimistic, but even if they prove accurate the company still provides reasonable value for the price over the long term.

I like that the company has three times as much cash as total liabilities, with no major spending commitments or off-balance sheet liabilities. The only contracted purchase was $1M worth of supplies and equipment that was completed in FY2011. Free cash flow has generally been positive throughout the past 10 years, except during the rough patch in 2007-2008. I see this as a positive sign from a business and shareholder perspective. Since the company produces enough cash to fund its working capital increases and capital expenditures with significant money left over, it is not dependent outside capital to grow or survive. This contributes to its strong balance sheet, which enables it to survive in difficult times. Two benefits from a shareholder point of view are the lack of dilution (as it’s able to fund growth internally) and the availability of cash for stockholder-friendly actions like buybacks.

HITK is not an asset-based value investment. The current market cap is more than twice the total asset value of the company. Licensed and patented drugs are definitely valuable assets for the company, and perhaps more valuable than their carrying value might reflect, but its most significant products (like generic Flonase) are not reflected on the balance sheet and in any case would not vastly increase net asset value.

Both sales and earnings have grown very rapidly over the past few years. Obviously investors are somewhat skeptical that this will continue, else the stock would not have a P/E of under 10.

Much of the growth has been supplied by the skyrocketing sales of generic Flonase. The valuation is in part the result of this product concentration. It’s important to note that most other areas of the business also experienced growth in FY 2010 and FY2011. Runaway success with fluticasone was very helpful, but others products also seem to have appeal in their niches.

Concentration does present a risk, but only a modest one. Flonase is an established product rather than a speculative development or new drug. It has been on the market for 17 years and thus has a mature market. It also has a fairly sizable one – four years after the expiration of their patent on fluticasone propionate, GlaxoSmithKline still reported sales of 800M pounds. For this reason I would expect that fluticasone sales, while they might not grow at the prodigious rate of the past year, would at least remain steady. It’s an accepted product with a stable market. The age of the product also reduces (but does not entirely eliminate, I must admit) the risk that catastrophic side effects would be discovered and lead to bans or litigation.

It might appear self-serving or dangerously optimistic to dismiss the the negative views of analysts to present a bullish case, but I think there are concrete reasons to question their conclusions. The first is their consistent underestimation of the company’s prospects for the past four quarters. Future FY estimates that were founded open overly pessimistic quarterly estimates are also going to underestimate future performance.

Second, the rapid growth in fluticasone market share from quarter to quarter means that even maintaining the market share achieved in Q4 results in a modest amount of revenue growth. Observe this chart of past and potential FY2012 sales:

I figure that Q4 and Q1 (February through July) will probably be the periods of peak allergy season and therefore the peak sales period and assigned those $27M in sales, essentially what the company achieved in Q4. The off-peak quarters get a slight increase in this scenario to account for the large increase in market share achieved in Q4. The loss of Lodrane from the product lineup is expected to reduce revenues for the branded prescription segment ECR by $16M. As you can see, a flat market share for Flonase suffices to overcome much of the shortfall from losing Lodrane. If fluticasone sales continue to rise, then the shortfall definitely disappears.

For a business where the biggest products are quite literally generic, quality management is crucial. One measure is consistently strong returns on invested capital. Over the past ten years HITK has achieved an average ROIC of 15.7%. Recent years have been even better, with a three year average above 24%. I prefer to focus on the first value, however, since I want to measure the success of management policies in general rather than just the single (obviously quite successful) decision to market fluticasone.

HITK’s focus on liquids, creams, and sprays builds a market niche. Their goal is presumably to take advantage of scale effects and strong reputation within their markets. According to company claims (which are difficult to properly verify without access to IMS sales data), 70% of their products are first or second in their respective markets as of 2010.

The biggest risk is of course that something will curtail sales of fluticasone or drag down its margins. As I mentioned above, the drug is old enough that surprising new effects are unlikely. Margin compression is a more likely possibility and the effects can be seen the in decreased importance of HITK products like dorzolamide, which has seen unit sales increase but sales prices decline drastically. This resulted in declining revenues from that drug despite its increasing sales. A quick scan of the SEC filings of other generic drug manufacturers (Mylan, Watson, etc.) did not suggest that any other big players were planning to enter this market, but it’s something to keep a watchful eye on.

There’s also management risk. Recent product decisions have performed well for the company, but many others have not. The acquisition of Midlothian Labs proved unwise and that company was recently divested at a modest loss, as was a previous were previous unsuccessful product acquisitions like Brometane and Naprelan. If the company hit a rough streak where these bad decisions outweighed the positive ones, investors would be in for a rough ride. Since the nature of the industry requires a constant search for new and better medicine, investors need to watch management carefully for signs that they are losing focus or making careless/overpriced acquisitions. The high cash balances make that a major point of concern, since rising ability to make purchases often becomes a rising incentive to buy regardless of price.

Another risk is the family element. David Seltzer seems to have demonstrated solid leadership, but the expensive involvement of his brother Reuben is troubling. Reuben Seltzer (a director and major shareholder) provides “legal and new business development services.” I suspect but cannot prove that this is a simply a cushy family job. Total payments to Reuben Seltzer in 2010 were $435,000 – nearly as high as David Seltzer’s salary (only $16,000 less) and 67% greater than the next highest paid corporate officer. I would also point to his lack of direct knowledge or experience in the field and his presumably disastrous tenure at Neuro-HiTech, a company where he was CEO and where the current value of HITK’s entire investment would perhaps pay for a nice meal. HITK is currently a 17.7% partner in a joint venture alongside Reuben Seltzer and is also invested with EMET Pharmaceuticals (where Reuben is a principal) developing generic drugs in a pharmaceutical field that is admittedly “outside of its area of expertise.” Between the money paid to Reuben in FY2010 and the $713,000 in R&D funds allotted to the EMET project over $1M was spent on the man last year. HITK could benefit substantially from ending this relationship, but realistically that will never happen and he will continue to be a modest liability for the company in years to come. It looks like HITK did a bit of work between the 2011 and 2010 annual reports to obscure the resources he is consuming, so I’ll probably do another post to take a look at that.

Before the Q4 financials came out, I would have listed the buildup of inventory as a potential sign that the company was betting too heavily on continued sales increases. The increase was not extraordinary, but it did exceed demand and might have signaled declining growth. Demand clearly proved to be present, since sales were up 45% in Q4 and 20% for FY2011. Accounts receivable, on the other hand, became more of a concern on the FY2011 statements. Receivables were up 45% year-over-year whereas sales were up only 20% and earnings 33%. HITK claims that there was a surge of orders late in March/April that have yet to be collected on, but that is certainly a substantial jump. I’ll probably want to do a bit more digging there as well.

In spite of the concerns listed above, I feel cautiously optimistic about HITK. It’s not a high-concentration bet, but it appears to be a simple and undervalued way to tap into the generic drug market.

HITK Hi-Tech Pharmacal Co

I’ve gotten a site up and running at http://www.dollarwisefl.com, so I’ll gradually be transitioning this blog over there now.

Posted in Analysis | Leave a comment

Mercer International

Mercer International recently caught my eye as a potential value investment. It currently sells for the low, low price of 3.47x earnings. It had an excellent 2010 (looks like the “absolute best year in company history” sort of excellent) and it is wildly cyclical, which explain why the valuation is so low. It also isn’t really in the tax-paying business right now, so I’d probably want to tax-adjust that P/E. Figure a 40% tax rate, so 3.47/(1-.4) gives an adjusted P/E of 5.78. The debt load is high for such a cyclical industry (770M Euros!), but the debt structure looks like it might be less risky than it appears at first glance. Worth a bit more digging, perhaps…

Posted in Potential Ideas | Leave a comment

MKS Instruments (MSKI) analysis

Current price: $24.61
Market cap: $1.286B
Book value: $911M
P/B: 1.41
P/E: 8.50
P/CF: 7.41
P/FCF: 8.46
EV/FCF: 5.94

MKS Instruments is a provider of instruments, subsystems, and process control solutions for markets like semiconductor capital equipment manufacturing that is selling at an appealing discount. Financial risk is almost non-existent and earnings- and profitability-wise the valuation is quite cheap.

Safety for an investment in MKSI is a relative term. The company, as its 2008-2009 results demonstrate, is going to ride the cycles of the semiconductor market up and down. The company has other product lines that account for a significant portion of revenues (about a third in 2010) and management intends to focus on developing a broader range of business, but investors hoping that increasing product diversity will ease the the big swings that come with the semiconductor market are being overly optimistic. Safety here means a rock-solid balance sheet that enables the company to ride out any kind of soft market with relative ease. Cash on hand is almost $480M, several times total liabilities, and capital expenditures are minimal and could easily be funded out of either free cash flow or the aforementioned store of cash.

As you can see above, the company is cheap on a relative basis, especially when the cash is taken into consideration. Profitability is also quite strong. ROA, ROE, ROIC, and CROIC (using free cash flow) are cyclical but definitely above-average. Business won’t be booming forever – you can actually see from the days sales and days inventory figures that it’s starting to slow down a bit – but the company produces solid returns on capital with a comforting level of financial security.

I think the biggest risk with MKSI is what Peter Lynch called the Bladder Theory of corporate finance – the more cash builds up on the balance sheet, the more urgently management feels the need to piss it all away. Large acquisitions that load up the balance sheet with goodwill are a potential value-destroyer and if management starts getting an itchy acquisition trigger finger it may be time to move along. In recent years management has made shareholder-friendly uses of cash by paying down debt, buying back stock, and declaring a dividend. This doesn’t guarantee future good behavior – $478M in cash is a lot of temptation – but it does buy them the benefit of the doubt.


Posted in Analysis | Leave a comment

Tata Sponge Iron Analysis

Current Price: 352.1 INR
Market Cap: 5.42 billion INR
Book Value: 5.071 billion INR
Exchange Rate: 45.17 INR to 1 USD
Ticker: TTSP.NS

Tata Sponge Iron (TSI) looks interesting. It’s got a P/E of 5.35, a yield of 2.28%, and P/B a bit over 1. It’s actually one of those companies that gives me the creeps: it’s cheap and I don’t see any reason for it to be such a bargain.

The company’s business is the manufacture of sponge iron, also called direct-reduced iron. It is partially owned (40% stake) by Tata Steel, one of the world’s larger steel companies. TSI has a relatively small share of the total Indian DRI market, about 1.5% as of 2009/2010. A total of 1.44B in sales went to Tata Steel in FY 2010, accounting for 27.6% of sales. Normally high customer concentration is off-putting to me, but the customer’s large ownership interest complicates the situation in this case. On one hand, the Tata Steel has a financial interest in continuing to do business with its affiliate (TSI), since moving its business elsewhere would knock down the value of their investments in TSI. On the other hand, Tata Steel would have a lot of power to push for deals that gave it preferential treatment at the expense of TSI and its shareholders. That doesn’t appear to have been a problem recently – margins and earnings look pretty strong – but that could change in the future.

TSI currently has a great financial position. The company currently has 1.8 billion INR in cash against zero debt and a market cap of 5.38 billion. The only threat to its financial stability would be the capital-intensive nature of its industry. Luckily it appears that the company is now producing enough free cash to fund its operations internally. Big capex years consume about 1B INR, but the company has produced operating cash flow in the billion-rupee range for several years now so that level of expenditure looks supportable. Shares outstanding have remained stable at 15M for many years and all long-term debt was paid down back in 2009.

Returns on invested capital have been fairly high for many years. Return on invested capital (using net income), cash return on invested capital (using free cash flow), and return on equity have typically been 20% or higher for the past five years. It looks like capital expenditures follow a three year cycle, where two years of modest capex are followed by a year with substantial expenditures of up to 1 billion INR. This causes CROIC to intermittently plunge, so a more accurate and less volatile figure might be a three year average. The average CROIC for 2008-2010 is 20.3%.

The company is small and not widely followed, so it’s difficult to know exactly which factors are spooking investors and keeping the valuation so low. My research leads me to think that potential areas of concern for TSI’s future would be the sponge iron market, the overall Indian economy, margin compression, competition, expenditure requirements, conflicts of interest between Tata Steel and other shareholders, and past valuation levels.

The health of the sponge/DRI market probably isn’t the cause. Figures here show that production had been increasing steadily for decades up until 2009, when it dipped from the global recession. It began rising again in 2010. India has provided more and more of the world’s production as the years went by. As of 2010 India accounted for 36.5% of world DRI production. As you can see, the growth curve leveled out in recent years (a comparison of annual growth rates is available in the spreadsheet at the bottom). Considering the size of its production share and the decelerating production, it feels fair to assume that production will rise long-term by a single-digit rate rather than the 25% CAGR of the past 30 years.

With that conservative assumption, TSI is undervalued based on its substantial ability to generate free cash flow. After all, if there is no need to expand capacity, there is no need for large expenditures and that cash could be put to profitable use for the shareholders. If, on the other hand, DRI production began increasing again in India, then its current valuation would be severely discounting its ability to serve the growing demand. Granted, it would need to at least maintain market share to participate in the DRI market’s overall growth but in that case the concentration of sales with a customer who (all else equal) has an incentive to buy with TSI would serve it well.

Tentative figures from the World Steel Association suggest that production is increasing once again. Total estimated Indian DRI production from the January – April period is 8.521 million metric tons. Annualizing that production level leads to a rough 2011 output of 34.084 million metric tons. Projecting that forward for the rest of the year seems reasonable given that monthly crude steel and iron output (2010 and 2009 for steel; 2008 for iron in Table 43) seems to vary little from month to month. Even if production falls off toward the end of the year, 2011 production is still on track to substantially exceed 2010’s 20.65 million ton output.

A bit of reverse-DCF might be useful to illustrate the kinds of assumptions that the market is pricing in. With a required rate of return (k) of .2,  net income of 1,013M, and market cap of 5.42B, this is the level of growth that the current valuation implies:

(in millions of INR)
5420 = 1013 / (.2 – g)
g = .0131 or 1.31%

That’s a pretty simplistic calculation, but it gives you an idea of the kind of implicit assumptions going on here.

The health of the overall Indian economy is a bit harder to judge. I don’t have any particular edge in judging where it’s going, so I’ll limit my analysis here to the possible impact of less-than-favorable economic outcomes. At its current price the company wouldn’t require runaway economic growth to provide a solid return to its shareholders. It produces a lot of cash and you’d be getting that cash flow dirt cheap. The main problem would be if the economy dipped into a recession. On that front, the massive growth of the Indian housing market is a red flag (gee, does that look familiar?). Steel consumption – and therefore iron consumption, since 98% of iron ore is used for steel-making purposes – in India is spread across a number of areas unrelated to the real estate market, but the economic effects of a major decline in real estate values would probably put a damper on overall steel consumption. Figure revenue dropping to something like FY2010 levels (fiscal year ends in March, so that’s primarily 2009 sales numbers) for a year or more in that case before steel consumption picks up again. TSI’s strong financial position makes this outcome a short-term nuisance rather than a solvency-threatening dilemma.

I think that margin compression might be less of an problem for investors, since they would be buying in when gross margin is approaching its 2007 low  rather than during a period of peak margins:

A bigger factor driving earnings – or rather, not driving them – would be that sales will probably be flat for the immediate future, since any expansion of existing capacity would take time.

Competition is definitely a concern since this is a commodity business with a small market share. Here again the self-interested customer/shareholder might be somewhat advantageous, since there is at least a modest incentive to make purchase from TSI. Management has also performed well by generating very strong returns on invested capital.

Expenditure requirements are probably the least of the company’s (and investors’) worries. Not only is DRI production a less capital-intensive process than blast furnace iron production – the process used to make pig iron – but the company currently produces enough cash (especially over a full multi-year cycle) to cover its expenditures.

To me, the company’s past valuation levels represent both the biggest puzzle and the biggest risk. Going by Reuters’ info, this outwardly healthy company has within the past five years traded for as little as 1.58x earnings. That period looks like it was in 2008/2009 when markets were bottoming out, but even still that’s unsettling to say the least.  It’s also worrisome to see that the peak valuation over the past five years has been 6.89x earnigns. As a result the single biggest risk to an investment in TSI appears to be valuation-based rather than business-based. Despite the fact that the company is cheap by virtually any metric, an investment here could be obliterated by these peculiar valuations or end up as dead money.

With that in mind I’d opt for a “safety first” approach. The fiscal years ends in March, so I figure the annual report ought to be up on their site within a month or so. A look at that might be a bit reassuring.

A few financial notes:
The “other expenses section” on the spreadsheets is the result of classifications by the Financial Times (the source of all the info). On the actual financial statements these expenses are all filed under the heading “Manufacturing and other expenses” and broken down in detail.

Since the financial statements use Indian-style numbering a quick explanation is in order. In Indian numbering, commas appear at the thousand, lac, and crore levels. A “lac” (commonly seen in the financial statements) is 100,000. http://en.wikipedia.org/wiki/Indian_numbering_system

Annual report
Financial Statements Breakdown and Iron Production

Posted in Analysis | Leave a comment

Allan International Holdings

Current Price: 3.74 HKD
Current Book Value: 757M HKD
Current Market Cap: 1,250M HKD
Exchange Rate: 7.77 HKD to 1 USD (fixed)

Allan International Holdings is a holding company based in Hong Kong that specializes in constructing household electrical appliances. It drew my eye with its low P/E (6.35), relatively high yield (6.15%), and rock-solid financial position.

AIH has virtually no debt and a cash balance of 332M HKD as of the interim report (Sep 2010). The company also has a recent record of positive free cash flow, so it has been able to fund its growth internally without needing to go to the capital markets. Both are good signs about the company’s ability to withstand another severe downturn, as is its strong performance during the last crisis.

Management has a significant stake in the company (44%) and seems to avoid any equity dilution. The family’s been running it for decades and it feels unlikely that they would suddenly put that at risk to grab a quick profit. Given the size of their stake and the length of their involvement it’s fair to say that their interests are aligned with outside shareholders.

So, why’s it so cheap? I see a few issues that might be putting off investors. There’s a lot of exposure to Europe, currency and commodity movements are squeezing margins, and receivables are way up as of the interim report.

I think that exposure to Europe is the least of AIH’s problems. Sales in Europe accounted for about 50% of FY2010 sales volume, so it is definitely the primary geographic region, but sales there held reasonably steady even during the financial crisis. Sales are invoiced in dollars, so the weak dollar ought to help sales, and national debt crises probably won’t prevent European consumers from replacing their blenders. It’s probably a short-term concern at most.

Margins will probably be a bigger issue. Gross margin is currently at a five-year high (possibly longer since I only went back five years) but is already creeping down towards the historical average. I’m not going to try to predict the direction/magnitude of commodity price changes over the next year or two, but to be on the safe side it would make sense to assume that gross margin would be at or below the level of 2008 (lowest of the past five years). Applying that assumption to TTM earnings basically cuts them in half and results in an adjusted P/E of 13.4.

The real issue comes from the growth of receivables. Receivables were way up at the interim mark and let to the company burning a lot of cash. A look at previous interim reports shows that mid-year receivable growth is something of a pattern for AIH, but this year’s growth was larger than in previous years and significantly outpaced revenue growth.

AIH has very substantial customer concentration (another issue I’m not thrilled about), which makes the receivables issue more serious. Their largest customer accounts for 49% of sales and the top five collectively provide 92% of sales. Since the biggest three customers account for 80% of receivables on average, I’d wait to see the receivables balance decline a bit before jumping in. AIH doesn’t seem to have had any problems with bad receivables during the recession and despite the pile-up receivables also don’t seem to be aging – only a small fraction more are more than 90 days old – but a problem with any of their major customers would result in a a substantial write-down as well as a major decline in future revenue. With that in mind I’ll take a lesson from SKX and steer clear of even potential working capital issues.

Their fiscal year ended March 31, so the annual report ought to be due out soon. That ought to clarify where the receivables issue stands. There is also a growing percentage of finished goods in the inventory. Inventory growth didn’t exceed revenue growth, but I’d like to see that play out a little more as well. Overall it seems like an interesting opportunity and the annual report ought to give a good sense of how serious these issues actually are.

Financial statements and vertical/horizontal comparisons: http://www.filedropper.com/allaninternationalholdings

Posted in Analysis | Leave a comment

York Timber Holdings (YRK:SJ) Analysis

Current price: R3.70
Current market cap: R1,205M
Current book value: R1,984.2M
Current exchange rate: 1 ZAR = 0.147 USD

York Timber Holdings is an integrated timber company based in South Africa. After severe brush fires in 2007/8 and poor FY2009 performance, the company’s stock plunged from above R9.00 per share to below R3.00. Investors like Jeremy Grantham are very positive about the prospects for timber and it’s frequently touted as an excellent hedge against inflation, so this seemed like an interesting opportunity to explore.

FY 2010 saw a lot of earnings improvement, but the true extent was buried under revaluations and write-downs. Biological assets were revalued upwards 10.5% after a switch to DCF valuation, reversing most of an impairment recognized in FY2009 and adding R200M to earnings. Impairments to goodwill resulted in charges of R42.6M. Directly removing all non-recurring charges gives an adjusted net income of R-93.1M or a total comprehensive income of R-29.6M. Definitely an improvement from 2009, but less so than the raw numbers lead you to believe.

Improvement did continue in the six months ending December 2010. Two factors appear to be behind the improvement. The first is the drastically lower interest costs from the company’s 2010 debt reduction. Proceeds from a stock offering (about R450M out of the total raised) were used to pay down a large amount of debt and a comparison of year-over-year changes in financing costs illustrates the large savings. This more than anything else, I think, helped get normalized earnings positive again. York also managed to maintain the improvements to its gross margin that it achieved in FY2010. In fact, it boosted gross margin all the way to 46%. It’s probably unrealistic to expect gross margin to remain quite so high, but it suggests that the cost-saving restructuring York has undergone genuinely paid off for the company.

Evaluating timber investments is a bit outside my circle of competence at the moment, but a quick comparison between York and a few U.S. timber companies demonstrates that it is fairly cheap on a relative basis:

Obviously York’s P/E is inflated by the aforementioned non-recurring charges (the same appears to be true of WY from what I saw), so that’s not a terribly useful point of comparison. To me the interesting points are the substantial difference in P/B ratios and gross margins between York and the others. Investors would be buying into an improving business at a big discount to book value, which looks like a promising combination. Those with the knowledge/desire to invest in timber might find solid returns with a margin of safety by moving a little bit off the beaten path.

Investing abroad does introduce other risks like currency fluctuations. That said, the Rand/Dollar relationship has been relatively stable over the long term in the past five years. In fact, the Rand appreciated a moderate amount since 2009 and would have benefited an investment made at that time. That’s probably at an end due to pressure from manufacturing groups, but it’s reassuring to see that the country’s currency has a recent history of stability.

A related point of interest is the rights offering that York used to fund its debt reduction. The rights offering price was set at R2 per share, up to 30% below then-current prices. Of course there’s the cost of the rights themselves to consider but prior to the offering the stock price was hovering around R2.50 per share with roughly 78.4M shares outstanding. Book value at that point was about R1.35B, so the regular trading price at the time was a substantial discount to book value even after taking into account the diluting effect of the new shares. The rights offering provided potential investors with an even greater discount. It had never occurred to me to search out special-situations opportunities outside of major countries because I had assumed that information would simply be too scarce, but at least in this case that would have meant missing out on a promising opportunity. That’s a useful lesson.

Website: http://www.york.co.za/default.asp
2010 Annual Report: http://www.york.co.za/imc/annual_reports/2010/York_AR_2010.PDF
Interim Report: http://www.york.co.za/imc/interim_reports/2010/YORK_interim_21122010ENG.pdf
Rights Offer Terms: http://www.york.co.za/imc/sens_pdf/declaration_data_announcement_final.pdf
Financial Statement Analysis: http://www.filedropper.com/york

Posted in Analysis | Tagged , | Leave a comment