BP, boring but cheap

What I find particularly interesting about this share is the extent to which the market does not seem to believe the earnings/cash flow/dividend targets of the company. The dividend yield is 8%. The 10-year Graham-Dodd p/e is under 12X, one of the lowest in the market (at least among large cap names). Admittedly the current earnings based valuation is flattered somewhat by the fact that capex is likely to run ahead of depreciation for while. Nevertheless, from an absolute return perspecive, I don’t think this valuation is sustainable if the dividend is not cut.

What will cause a cut in the dividend? Two possibilities: 1) Management cannot cut costs suffiently to bring the business in line with a lower oil price world; 2) Oil price goes down and stays down. I think the results this week showed that we can worry less about point 1) as they have already reduced costs by 1.2bn versus 2bn target for the full year.

The second point is clearly a risk. However I think one needs to question much of a risk it really is given where the valuation currently lies. Assuming they cut the dividend in half the share will still yield 4%. If oil goes to $30 and stays there for 3 years the share will probably underperform, but I am not sure it will underperform by that much given the implications of $30 oil for the rest of the global economy. And this must be the only scenario in which an investment would lose money in an absolute sense.

If the oil price stays flat at $50 or goes up to, say, $75, then the share will certainly go up in absolute terms, and probably relative also (although clearly it will underperfom the oil beta names).

Personally, I would be buyer of this share whether on an absolute or relative basis simply because the valuation currently looks so appealing.

Safety in semis?

Safety is perhaps not the right word, as you can probably never have safety in the semi-conductor space. The speed of product innovations and the severity of the cycle can potentially blow you out of the water at any time.

Nevertheless, two UK small caps that might be worth a closer look are CSR and Wolfson Microelectronics. Both companies operate in the semi-conductor industry. They are “fabless”, which means they do not manufacture their own semi-conductor wafers (a highly technologically intensive and expensive process). Rather they buy the wafers, and then use them in their own products that are sold onto end customers, mostly in the consumer electronics industry. CSR specialises in wireless connectivity, particularly Bluetooth. According to their annual report, last year they shipped 40% of the world’s Bluetooth chips. Wolfson’s specialises in audio chips, targeting newly released consumer electronics products where quality is paramount. They have a reasonably diverse end market customer base including handset OEMs, personal media players, games consoles, TVs etc.

Both companies have a number of issues. In the near term, the global recession is hammering, and will continue to hammer their revenues. Estimates for Wolfson’s 2009 revenues have fallen by nearly 50% in the past 9 months. Longer term, there are also some concerns about loss of market share to larger competitors. For CSR, the concern is that handset OEMs and other customers will move toward multi-purpose chips that do more than just Bluetooth. Indeed this is one the reasons the company has recently bought out a struggling GPS chip computer with a view to combining their products together. Wolfson faces similar issues, having recently lost a the I-pod contract to a US competitor.

All doom and gloom them? Not entirely. The potential attraction of these companies is the valuation. Both shares have fallen around 80% from their peaks in 2006. Back in the bull market the market looked to price the shares off expected earnings. Margins and returns were high on the back of the worldwide consumer boom. What is interesting is that the shares have now traded down to a level that is not far off the liquidation asset value.

Using Ben Graham’s approach of ignoring all the intangible assets and netting off the total liabilities against the tangible assets, we come out with share prices not a million miles away from current prices. Marking the 2008 year-end property and inventory at 50%, the receivables and cash at 100%, and netting off all the liabilities gives a net asset value of $109m for Wolfson and $276m for CSR (both companies are dollar reporters). Converting into sterling this gives per share values of 65p for Wolfson and 148p for CSR.

Granted, after the recent risk rally, both shares currently trade higher than these levels – Wolfson is at 108p and CSR is at 240p. However, one would have to be very negative indeed about future prospects for either company to argue that they should trade in inline with the tangible net assets on an ongoing basis. Under any scenario which does not involve permantly collapsing end markets, both companies continue to generate cash and deliver high returns on equity and capital employed. And presumably at some point the consumer electronics market will at least start to stabilise. Even for 2009, both companies expect to deliver at worst flat cash flow (although this may tougher for CSR now following their acquisition). Also worth noting is that both shares did actually trade more or less in-line with the net-tangible assets back at the lows in February and November 2008 (they have both risen c.55% since). If we do see a pull back in markets, I would definitely look to start buying these stocks if they start to trade back down toward the tangible asset value.

Wolfson report Q1 on Wednesday. It will be interesting to see what they say about the full year outlook and what their cash flow situation looks like for Q1 which will surely be one of their worst quarters ever.

Margin of Safety

I recently ran into a copy of Seth Klarman's classic, "Margin of Saftey Risk Averse Value Investing Strategies for the Thoughtful Investor". Out of print, they sell for $700 second hand, but copies appear to be going around electronically (Sorry Mr Klarman , but I am sure you would rather people were reading it than not).

This book was written in 1991 and has not been updated since. Nevertheless, I am struck by the timliness of the arguments and insights, especially considering all the extraordinary events that have taken place in the financial markets since then. E.g:

Investment Fads:

"There are countless examples of investor greed in recent fianancial history. Few, however, were as relentless as teh decade-long "reach for yiled" of the 1980s... Known among Wall Streeters as "yield pigs", such indivudual and institutional investors were susceptible to any invstment product that promised a high rate of return. Wall Street responded with gusto, as Wall Street tends to do when there are fees to ear, creating a variety of instruments that promised high current yields."

Short terminism of Wall Street:
"The utter hypocrisy of Wall Street is exemplified by the "equitization" wave of early 1991, whereby overleveraged comanies issued equity and used the proceeds to repay debt. Wall Street collected investment banking and underwriting fees when those companies were acquired in highly leveraged junk-bond financed takeovers and collected large feees again when the debt was replaced with newly underwritten equity."

"Investment bankers in Wall Street firms are constantly creating new types of securities to offer to customers. Occasionally such offerings both solve the financial problems of issuers and meet the needs of investors. In most cases, however, they address only the needs of Wall Street, that is, the generation of fees and commissions."

"Investors must recognize that the early succss of an innocation is not a relaible indicator of its ultimate merit. Both buyers and sellers must believe that they will beneft in the short run, or the innovation will not get off the drawing board; the longer-term consequences of such innovations, however, may not have been considered carefully... Neither cash-hungry issuers nor greedy investors necessarly analyze the performance of each financial-market innovaation under every conceivable economic scenario. What appears to be new and improved today may prove to be flawed or even fallacious tomorrow."

Short-terminism of institutional fund managers:

"Like dogs chasing their own tails, most institutional investors have become locked into a short-term relative-performance derby... Frequent competitive ranking can only reinforce a short-term investment perspective. It is understandably difficult to maintain a long-term view when, faced with the penalties for poor short-term eformance, the long-term view may well be from the unemployment line."

Failure to understand leverage:
"The relaxation of investment standards by junk-bond investors was accompanied by the dangerous misconception that the amount of debt and equity in a company's capital structure junior to one's own investment provided a degree of protection. It was as if the value of a business existed on the liability side rather than on the asset side of its balance sheet. Although it may be superficially reassuring to know that there are investors in a company whose claims are subordinated to your own, this information is of little, if any, value in asessing the merits of your investment."

Failure to understand risk:
"The view that risk is dependent on both the nature of investments and on their market price is very different from that described by beta... [R]isk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment. If an exploratory well proves to be a dry hole, it is called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made? Not at all. The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made."

Banks and financial companies:
"Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy. The stock market says there is no problem, so there is no problem. Ine early 1991, for example, Citicorp stock traded in the teens and the company was able to find buyers for newly issued securities. If its stock price had been in the low single digits, however, it would have been unable to raise additional equity capital, which could have resulted in its eventual failure. This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome."

Forecasting
"Some sources of earnings growth are more predictable than others. Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behaviour... On the whole, it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialise and how it will affect profits."

Time to take on the debt recovery trade?

“While a speculative capitalization structure throws all the company's securities outside the pale of investment, it may give the common stock a definite speculative advantage... Because of this fact there is a tendency for speculatively capitalized enterprises to sell at relatively high values in the aggregate during good times or good markets. Conversely, of course, they may be subject to a greater degree of undervaluation in depression. There is, however, a real advantage in the fact that such issues, when selling on a deflated basis can advance much further than they can decline.” [Security Analysis, B.Graham and D.Dodd, 1934 ed, p466]

Consider two companies, A and B. Operationally both are identical in all respects. Both have £1bn in revenue, £150m in EBITDA, and an annual £20m maintenance capex requirement (2% of sales). Over the next three years revenues, margins and capex at both businesses will be flat. So these are reasonable businesses - defensive, but with little growth prospects.


The only difference between the two companies is how they are financed. Company A is entirely equity financed, while company B is levered to 3.5X net debt/EBITDA. Mr Market has decided that the enterprise value for these businesses is £800m - i.e 0.8X EV/sales, a low valuation in normal times for businesses such as these but not inconceivable in current markets. So company A has £800m market capitalisation, while company B has only £35om because it is carrying £450m in debt. Because company A has no debt issues the Board has decided that it should pay out 100% of its free cash flow as dividend. Company B has decided that it will pay out only 50% of its free cash flow, so that the other 50% can go into paying down the debt burden (which the market does not like).


Lets consider what a simplistic p&l and cashflow will look like for these two companies.





Under these (admittedly very simplistic) assumptions, it is clear that the "overlevered" company generates a superior total return. Why is this the case? The reason is that the company is still highly cash generative. Each year the debt is paid down by the cash flow, which means the equity portion of the EV rises as the debt portion falls. Meanwhile shareholders are also picking up a sizeable dividend yield on the smaller equity base.


So, does this mean we should be buying companies with debt? Not necessarily. Clearly the above example is only valid if a number of factors are in place.


1) The market must be valuing the EV and equity of the company in this way - i.e. the equity must be at a suitably depressed price versus unlevered peers.

2) There must be a high level of confidence in the EBITDA and cash flow forecast for the levered company. If this is not the case then the financial leverage could quickly see the cash flow dissapear and hence there will be no capital appreciation. This will tend to mean companies that have reasonably defensive revenue streams.

3) There must be no big refinancing looming. Or, if there is, one must be sure that it is not going to have adverse consequences for the company.


In the UK market there are a number of companies (mostly mid-cap) that potentially satisfy these criteria such as: Informa, Premier Foods, Meggitt, FirstGroup, Melrose.