Author Archives: Roland Head

Royal Mail sorting parcels

Results review: Royal Mail plc delivers progress but value is uncertain

Royal Mail sorting parcels

Source: Royal Mail

Roland owns shares of Royal Mail.

FY17 results: 18 May 2017

My review of Royal Mail’s 2016/17 full-year results.

Royal Mail is a holding in another of my portfolios. This has historically focused on income, but I’m now shifting it towards my value strategy.

I’m trialling a new format for this article, based on my personal notes on the stock. My hope is that posting like this will enable me to post more often around other work commitments. But let me know if it’s too hard to follow.

Comments

The narrative seems reasonably positive. Ongoing shift to focus on parcels and manage the decline of the letters business. Growing contribution from international GLS business.

However, it’s also worth remembering that Royal Mail already has a 50% share of the UK parcels market. The group is aiming to keep this share steady, growing in line with the parcel market (about 3% p.a., according to Royal Mail figures). Significant market share growth could be unlikely, as competition from Amazon and other parcel operators appears to be intense.

This is a key risk, in my view — retaining this dominant market share is probably essential to ensure the profitability of Royal Mail’s universal delivery network. Any reduction in market share could be seriously bad news.

Total capex has fallen from £694m in FY16 to £529m in FY17. Guidance for FY18 is c.£450m, with sub-£500m expected for the foreseeable future.

Earnings analysis

Reported eps rose by 14% to 27.3p, so the stock looks fully priced on a P/E of c.15 @ 435p

Adjusted eps is more encouraging at 43.8p, giving a P/E of about 10. Are the adjusting items reasonable (in my opinion)?

Operating adjustments:

  • Transformation costs £137m (FY16: £191m) – Good to see this number falling. But I’d still include these costs in my calculation of operating profit, as in my view they’re necessary for both the present operation and the future survival of the business.
  • Employee free shares £105m (FY16: £158m) – I’d normally argue these were part of remuneration and should not be adjusted out, but in this case the free shares appear to have been gifted by HM Government into trust for distribution to employees (see 2016 Annual Report Note 15). So for the time being, it seems fair to ignore the income statement cost of these, as the actual cost to RMG appears to be zero.
  • The other adjusting items to operating profit are small and perfectly fair, in my view.

My estimate of ‘clean’ FY17 operating profit = £324m (FY16: £296m)

This gives an operating margin of 3.3% (FY16: 3.2%) and an earnings yield (EBIT/EV) of 7.3%. The operating margin is low but the earnings yield is quite attractive. Thus these figures suggest to me that the current valuation of the group is quite attractive, relative to its profitability.

Non-operating adjustments:

  • Net pension interest: £120m (FY16: £113m) – Royal Mail’s pension scheme is currently running a surplus, hence this line item. But it’s an accounting item only — it’s non-cash and isn’t a business-related gain. So in my view it should be excluded from earnings per share.

My estimate of ‘clean’ FY17 pre-tax profit = £320m (FY16: £283m)

The average tax rate over the last two years is 17.7%. Using this rate gives:

My estimate of ‘clean’ FY17 after-tax profit = £263.5m (FY16: £232.9m)

My estimate of ‘clean’ FY17 earnings = 26.3p per share (FY16: 23.3p)

This gives a trailing P/E of 16.3, which isn’t obviously cheap for a low-growth business. Does the cash flow situation paint a more favourable picture?

Cash flow analysis

The beauty of the cash flow statement is that you don’t need to worry about non-cash items distorting the results. The only adjustments I might make here are based on my view on whether a cash item is truly exceptional or not.

The figures from last year’s cash flow statement seem to confirm my view on profits. Free cash flow is the metric I’m most interested in here, given that this is a dividend stock with low growth expectations.

I’ve calculated free cash flow to equity on this basis:

Free cash flow to equity = Net cash inflow from operating activities – net cash outflow from investing activities – finance costs paid – payment of obligations under finance lease contracts

My calculations indicate free cash flow to equity = £153m (excluding acquisitions = £275m)

Note re. acquisitions: I usually exclude acquisitions from free cash flow calculations, but in this case I haven’t. Royal Mail has made similar sized (fairly small) acquisitions in each of the last two years as part of its growth plans for GLS. This seems likely to continue, so I want to see if the dividend is affordable alongside these costs.

The cost of the dividend last year was £222m, exceeding my estimate of the free cash flow available for shareholder returns. That’s one possible reason why Royal Mail’s net debt rose from £224m to £338m last year — the group’s cash flow wasn’t enough to support its transformation costs, acquisitions and dividend.

I’m not concerned about Royal Mail’s use of debt or its level of gearing, yet. But it’s something to watch.

Profitability

I’ve done a quick calculation of return on capital employed for Royal Mail. The results are quite interesting:

  • FY17 ROCE (including pension surplus): 5.1%
  • FY17 ROCE (excluding pension surplus): 13.1%

These figures suggest that Royal Mail’s underlying business does generate a reasonably attractive return on capital employed.

Dividend

A key attraction, the full-year dividend has been increased by 4% to 23p per share, giving a trailing yield of 5.3% at a share price of 430p.

The yield is attractive, but dividend cover is poor based on my eps estimate of 26.3p per share and on the group’s reported eps of 27.3p per share. Dividend growth may be limited over the next few years.

Conclusion

Royal Mail has 50% of the UK parcel business. With such a dominant market position, I don’t think it’s reasonable to expect anything more than low single-digit growth in parcel revenues. The group is hoping that its international GLS business (of which Parcelforce is the UK arm) will provide some growth to offset the decline in the letters business.

If you’re wondering about the discount to book value which shows up on some data services, I’d be aware that that this is only due to the pension surplus, which was listed as a £3.8bn non-current asset for FY17. Even if this persists (we’re told it won’t), I don’t see this as an attraction for equity investors. Stripping out the pension surplus gives a book value of about £1.2bn, putting Royal Mail on a pension-adjusted price/book ratio of about 3.7.

In my view, Royal Mail’s current valuation is probably attractive for income investors. This was the original reason for my purchase of the stock.

I’m moving away from income to focus more heavily on value. And I’m less certain whether Royal Mail is cheap enough to qualify as a value buy. Although the earnings yield and ROCE are fairly attractive, the parcels business is fiercely competitive. I’m not sure how much room the group will have to increase profits or margins, especially as it will have to maintain capacity in its declining letters business.

Overall, I’d rate the stock as a hold. I’m going to mull it over, but may soon sell some or all of my holding.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

A tunnel in a deep mine

New stock: Why I’ve added Highland Gold Mining Ltd to my portfolio

A tunnel in a deep mineDisclosure: Roland owns shares of Highland Gold Mining, Kingfisher and Millennium & Copthorne Hotels.

I’ve been on something of a spending spree recently, adding three new stocks to the portfolio so far in May.

You can see all the details on my portfolio page, but in short the companies are B&Q owner Kingfisher, FTSE 250 group Millennium & Copthorne Hotels and Russian gold miner Highland Gold Mining Ltd (LON:HGM).

I’ve thought long and hard about whether to invest in gold. I’m not a gold bug, but the market for gold now seems fairly stable. On that premise, a number of cash generative and low-cost gold producers have started to show up in my value screens.

Highland Gold Mining has emerged as the winner from a short list of three:

  • Centamin
  • Pan African Resources
  • Highland Gold Mining

Centamin: I ruled out Centamin because of its ongoing legal problems in Egypt. The biggest worry is that a case challenging the validity of its mining licence will go against the firm. I also feel that on 17 times forecast earnings and 1.7 times book value, Centamin stock is quite fully valued at the moment.

Pan African Resources: I’v nothing against this South African/Zimbabwe-based miner, but free cash flow has lagged behind earnings over the last few years. Plus I find PAF’s RNS announcements unnecessarily confusing and difficult to read. I also have concerns about the ongoing labour relations problems afflicting South African miners. These are justified, in my opinion, but nevertheless are a deterrent from an investment perspective.

Why Highland Gold?

Having ruled out Centamin and Pan African Resources, I decided to go with Russia-focused Highland Gold Mining. This is something of an oligarch stock, with backers including Roman Abramovich and former Sibneft president Eugene Shvidler.

The company was founded in 2002 “for the purpose of acquiring, consolidating and developing a portfolio of quality gold mining projects in the Russian Federation”. It’s been reasonably successful. In common with most Russian miners, costs are low by industry standards. Cash generation is strong and the firm pays generous dividends.

One downside of HGM’s ownership profile is that the free float is only 50%. But Highland Gold has traded continuously on AIM for 14 years. It has a far better trading record than many more freely-held commodity stocks. I’m also reassured by the presence of Canada’s Barrick Gold on the shareholder register. Barrick has a 20% stake in HGM, which would seem likely to give it the casting vote in the event of any corporate action.

The stock looks affordable to me

I’ve not carried out an in-depth analysis of the quality of Highland Gold’s mines or reserves. Such a task is outside my competence and would take more time than I have available. So I based my decision to buy on key performance measures and valuation metrics.

  • Spot gold price 12/05/17: $1,228/oz
  • 2016 all-in sustaining cost AISC: $652/oz
  • P/B: 0.8
  • Trailing P/E: 12.2
  • Trailing P/FCF: 7.5
  • Earnings yield (Op. profit/EV): 11%
  • Net debt to net profit: 4.3x
  • 2017 forecast P/E: 10.8
  • 2017 forecast yield: 6.5%

In my view, these are all attractive values, with the possible exception of the net debt. However, net borrowing fell from $231m to $205m last year. The group’s cash generation leads me to expect further reductions this year. I don’t think this level of gearing is likely to cause a problem.

My overall view is that HGM looks good value at current levels. The yield is attractive and the group’s low mining costs should help to ensure a reliable stream of free cash flow, regardless of the price of gold. On that basis, I recently added Highland Gold Mining to my value portfolio.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Shanghai skyline

New stock: A stay at Millennium & Copthorne Hotels plc could prove profitable

Shanghai skyline

Disclosure: Roland owns shares of Millennium & Copthorne Hotels and Hargreaves Services.

In this post I’m going to look at one of two new stocks I’ve recently added to my value portfolio. A second post will follow, covering the second addition.

Buying stocks which trade at big discounts to their tangible net asset value is often riskier than Ben Graham devotees (of whom I am one) would have you believe.

Although it’s worked out well for me with Hargreaves Services, the liquid and heavily-analysed nature of modern markets means that mid-cap or larger stocks rarely trade at big discounts without good reason.

Notwithstanding this risk, I’ve recently added FTSE 250 hotel group Millennium & Copthorne Hotels (LON:MLC) to my portfolio. This luxury hotel group was founded as CDL Hotels International in 1989, as a subsidiary of the Singapore-based Hong Leong group.

Today, MLC is controlled by City Developments Ltd (SES:C09), a Singapore-based property group with a market cap of £5.4bn.

I think it’s fair to say that the whole enterprise is essentially a family business: both MLC and City Developments were founded by members of the Kwek family, which runs the Singapore-based Hong Leong group.

Why buy?

The opportunity on which I’ve based my purchase is that at 450p, Millennium & Copthorne currently trades at a 54% discount to its tangible book value of 989p per share. That’s despite having a strong balance sheet and an improving outlook.

MLC’s shares have historically traded at a discount of around 20% to book value (e.g. in 2015, book value was c.700p and the share price was about 580p). This suggests to me that the current discount is exceptional and should narrow as and when the firm’s profits recover. My calculations suggest that a return to a 20% discount to NAV would imply 50% upside from a share price of 450p.

Although trading has been disappointing over the last year, I don’t see this as a reason to write down the value of a large portfolio of upmarket hotels in prime city locations across the world.

In the short term, the current valuation doesn’t seem excessive. I’m also reassured by the group’s low level of gearing:

  • 2017 forecast yield of 1.8%
  • 2017 forecast P/E of 15.7
  • Net debt of £710m, versus fixed assets of £4.3bn.

One other point in favour is that analysts’ forecasts have recently been upgraded for both 2017 and 2018. This graph from Stockopedia shows the recent improvement in City sentiment:

MLC Broker forecast trend May 2017

MLC broker forecast trend May 2017 (source: Stockopedia)

What could go wrong?

As far as I can see, there are four main risks:

1. A bid is unlikely: MLC’s majority-owned structure means that a bid  from an external buyer is very unlikely. In last year’s third-quarter update, management reiterated its commitment to a long-term ownership strategy: “The Group has a long term perspective and considers asset ownership as key to its strategy.”

2. No shortcuts: This commitment to asset ownership also means that MLC is unlikely to turbocharge its returns in the way that its FTSE 100 peer InterContinental Hotels has done. InterContinental’s franchise/management model makes it hugely profitable, but net fixed assets have shrunk from £2.2bn in 2012 to just £857m at the end of 2016.

My reading of MLC’s Asian owners is that they are shrewd and share my view that over the long term, the value of prime real estate in major cities is only ever likely to rise. They won’t exchange this advantage for shorter-term profits.

3. Valued by yield, not assets: Points 1 and 2 could mean that the market only values MLC by its dividend yield. As this is already low, at about 1.8%, the shares could stagnate until the company lifts the payout.

4. Not very profitable? MLC’s business will continue to struggle in an indifferent global market. In my view, this is a short-term risk that’s unlikely to be a longer-term problem. Improved management, currency shifts and other cyclical factors should mean that profits reflect the quality of the assets.

Points one through four are all valid risks that could limit the profitability of my investment. But in my view, none of them imply any particular downside risk. Even if the shares don’t go up, the risk of a long-term decline seems low to me.

On that basis I’ve added Millennium & Copthorne Hotels to my portfolio. I see this as a safe long-term buy with decent upside potential from asset backing and improvements to profits.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Offshore oil or gas platform

Portfolio update: BP, Hargreaves Services & Gattaca

Disclosure: Roland owns shares of Gattaca, BHP Billiton and Hargreaves Services.

Today I’m going to provide an update on recent changes and news affecting three of the stocks in my portfolio, BP plc (LON:BP), Hargreaves Services plc (LON:HSP) and new arrival Gattaca plc (LON:GATC).

BP: sold

After watching BP’s share price regain some of the ground it lost at the start of the year, I decided to sell. There were two main reasons for this.

The first is that my portfolio retains oil exposure through a holding in BHP Billiton. Although BHP isn’t a pure play on oil and gas like BP, it does have a more attractive financial profile than BP. In particular, BHP Billiton boasts three attributes I like and which BP lacks:

  • Strong free cash flow
  • A dividend that’s comfortably covered by both earnings and free cash flow
  • Falling net debt and lower gearing than BP

The second reason I sold BP is that I wanted to free up money for new and — I believe — better opportunities elsewhere.

I suspect BP remains attractive as a long-term energy pick, but I don’t find the current valuation compelling. So after just over a year, I’ve sold my holding in BP for a respectable gain:

  • Total return (after costs, including dividends): 50.6%
  • Annualised total return: 42.6%

Hargreaves Services

I’ve been waiting patiently for Hargreaves’ management team — who I rate highly — to report progress on their plans to monetise the company’s land bank. On 29 March the firm released a RNS which sent the shares up by 20% in one day (my bold):

Hargreaves Services plc (AIM: HSP), a diversified group delivering key projects and services to the infrastructure, energy and property sectors, is pleased to announce that it has today received planning approval in principle for 1,600 new homes at Blindwells, on part of a 392 acre site near Tranent in East Lothian, which is situated less than 15 miles from Edinburgh city centre. The approval, which includes affordable housing and mixed use development, represents the first phase of a wider master plan for more than 3,200 homes to be developed over the next 12-15 years.

The Blindwells site was an open cast coal mine until 2000. Hargreaves will need to spend £5m to put in some infrastructure but the assuming the housing market remains stable, this looks to me like a big win for the group.

According to Hargreaves’ RNS, “the grant of planning is expected to generate a meaningful uplift to the market value of the Blindwells site” relative to its book value, which was £129.2m as of 30 November 2016.

An independent valuation of the group’s property portfolio is underway and will be published with the group’s results in August.

Hargreaves’ stock has risen by 24% so far this year. The tangible value of the firm’s assets is starting to be reflected in the group’s share price. However, I believe there is likely to be more upside to come. Obviously this isn’t without risk: the housing market or a dislocation in financial markets could threaten the group’s plans.

To reflect the risks but remain exposed to potential upside, I trimmed my holding in the wake of this news. Notwithstanding this, Hargreaves Services remains one of the largest holdings in my portfolio.

Gattaca

With masterful timing I added Gattaca to my portfolio on 6 April, seven days before the small-cap recruitment group issued a profit warning.

Full-year profits is now expected to be 10-15% below previous expectations. This isn’t disastrous — I estimate it puts shares on a forecast P/E of about 8.5.

The explanation for the expected profit miss sounds reasonable to me and should be a one off. Several factors were mentioned:

  • Slower hiring during H1 following the Brexit vote.
  • Unexpected one-time costs relating to setting up “new international entities” to support a European contract win, plus more general spending on infrastructure upgrades.

However, the group’s sound more confident about the medium term, saying:

Given the opportunities we see, the Group has continued to strategically invest in sales headcount, up 24 since 31 July 2016 and we expect to see a return on these investments during the second half and beyond. We are particularly confident that the headcount investments which we have made in our overseas businesses will lead to accelerated growth next year.

This does worry me

In my view, what’s more worrying than the profit warning itself is that it reflects poorly on management credibility. Last week’s warning came just over two months after a far more bullish trading update in February, when the Board had this to say about the FY outlook (my bold):

Having made these investments over the last 12 months, the phasing of planned client projects in the second half of the year and, encouragingly, the improving performance of our IT Division, the Board has confidence that profit for the full year will be in line with its previous expectations.

Did the board really have no visibility of the issues raised in last week’s profit warning in February?

Is the dividend safe?

There was no mention of the dividend in last week’s profit warning. But a second concern must surely be that Gattaca will be forced to cut its dividend. The stock currently offers a forecast yield of 8.5%.

A yield that high is usually a warning that a cut may be required. Although the forecast payout of 23.3p should still be covered by earnings, which I estimate at about 33p per share, the problems mentioned above may have had a disproportionate effect on short-term free cash flow.

While Gattaca’s last-reported net debt of £25m is very manageable, I wouldn’t want the firm to borrow more simply to maintain the dividend. A modest cut to the payout might be more prudent.

However, that’s all in the future for now. I haven’t made any changes to my Gattaca holding following the profit warning, and continue to hold.

Assuming there are no more profit warnings in the pipeline, the firm’s next update should be interim results on 20 April. I’ll comment here if anything material changes in my view of the firm after the figures are published.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

A picture of a CPU

Is Murgitroyd Group plc poised for a recovery?

Disclosure: Roland owns shares of Murgitroyd Group.

A short post to introduce one of the latest additions to my value portfolio.

Murgitroyd Group (LON:MUR) is a £36m firm specialising in “intellectual property advisory services”.

The main part of the business seems to be providing patent attorney services and the group operates throughout Europe. It’s also active in the US, where it’s targeting longer-term growth by selling European patent services to US companies.

Murgitroyd’s share price fell by about 25% in one day in January, after the company warned investors that first-half profits would be below expectations. Full-year profit guidance was also cut. I am generally a believer of the adage that profit warnings often come in threes, so I’d normally have stayed away a little longer.

However, last week’s third-quarter trading statement was much stronger than expected, advising investors that:

“The Board also confirms that the underlying trading result for the third quarter was much improved on the first half performance and ahead of revised internal forecasts for the period.”

A further trading update is expected in June 2017. Arguably I should have waited until then to consider a buy. But I’ve been tempted by the company’s strong balance sheet and value credentials.

I’d also argue that this sector is only likely to expand over the coming years, providing attractive growth and consolidation opportunities for a mid-sized player such as Murgitroyd.

Why I bought

Here’s a short summary of Murgitroyd’s financial attractions:

  • 10-year average eps growth rate of 4.6%
  • 10-year average dividend growth rate of 6.2%
  • Earnings per share convert consistently to free cash flow — around 72% cash conversion since 2011
  • Free cash flow consistently covers the dividend, usually by a large margin
  • Debt free with net cash of £1.1m, which is a significant amount relative to TTM net profit of £2.7m
  • 5-year average ROCE of 16%
  • Forecast P/E of 13, falling to a P/E of 12 for 2018
  • 4% dividend yield

This appears to be a consistently profitable and cash generative business, with a moderate valuation and stable long-term growth.

Another point worth noting is that founder Ian Murgitroyd remains chairman of the group, with a 26.8% shareholding. Edward Murgitroyd, who I assume is his son, has a 4.3% stake and heads up the group’s US presence in his role as vice chairman. This family ownership ought to ensure that the focus remain’s on sustainable long-term growth and that acquisitions are proportionate and carefully considered. I hope.

In any case, I’ve bought some Murgitroyd shares and await the trading update in June and the firm’s full-year results in September with keen anticipation.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.