SmallCaps.co.za

1. Curro: Divergence of Strategy and Reality

   I get a really uneasy feeling when a CEO's opinion and promises start to become moving targets with shifting goal posts. Investing in shares is really investing in the management team running the underlying company. And, investing in a management team is really built on trust. Trust is built by sticking to ones word.

    

   Changing opinions and shifting goals does not foster much trust.

    

   Any listed company with growth ambitions should have a strategy in place to achieve this growth. Not just is this strategy important as a guideline for management to execute, but it also becomes the intangible object that investors are investing in: the future cash flows of the company.

    

   What is an investor's most common starting point in trying to forecast the future? Always management. And what management will always tell investors is what the company's strategy is and how they plan to execute it.

    

   Any corporate growth strategy has three main variables:

   1. Quality: Is it a good growth strategy? Does it 'work on paper'?
   2. Execution: Even if the growth strategy is a good one, does management execute it correctly? No matter how great it looks on paper, does it work in reality?
   3. Reality: Is the strategy even being executed at all, or is management doing something else entirely?

    

   The last point is perhaps the most important, as a director of a company is in a position of immense trust. A minority investor invests in a company based on the promises of a CEO asserting what the said company's strategy is. This minority investor then comes to a conclusion of the company's future based on this strategy and its expected execution. That same investor would feel pretty betrayed if the CEO does not then execute what he has promised to execute.

    

   For example, let's say that a company comes to the market promising to construct private schools at a rate of three to four new schools a year. The CEO promises certain targets of learners and certain cash flows and profits at certain points along the way.

    

   Now, the first part of that scenario is a strategy, while the second part is really just management guidance.

    

   Management guidance will never be perfect, as profits and cash flows are variable. Still, any quality management guidance should at least be pretty close to what the company eventually reports. If not, questions have to asked why management guided to those figures at all in the first place?

    

   So, this private schooling company's strategy is to grow by constructing a couple new schools a year. There are a couple aspects to this sentence, of which I am going to focus on just one: constructing schools.

    

   Organic growth tends to be slower, but safer than acquisitive risk. Hence, if the company's strategy is basically to attack the private schooling market by growing organically, I can build this into my investment decision, my time horizons, my models and my overall assessment of the risk of the investment and final decision to buy the shares or not to.

    

   And then the private schooling company starts aggressively acquiring other private school businesses.

    

   And misses its stated profit targets.

    

   In this example, as a market analyst, I would start to grow increasingly uneasy of management. I return again to the element of trust and how, arguably, in this situation it has been broken or, at least, very much strained.

    

   In the above example, the company is Curro (COH) and I am growing increasingly uneasy of management. For some background on Curro, have a glance at the article I wrote shortly after it listed: COH: Enthusiasm could be expensive.

    

   Now, let me run you through the course of events surrounding Curro:

    

    

   1. Curro publishes its pre-listing statement, noting that a competitive advantage Curro's is that its school fees are some 20% to 40% less than other role players in the private education market. The reason for these lower school fees is because Curro constructs its own schools and can do so cheaper than other players (who tend to contract an outsider to construct the schools). (Clause 1.3.2.3 of Curro's prelisting statement. Also have a look at Clause 1.1.8 where Curro uses the very specific phrase "By building schools in middle to affluent areas, Curro frees up valuable Government resources that can be spent in less affluent areas.")
   2. Curro lists and raises over R322m via a rights issue in its script and ear-marks this capital for the execution of its stated strategy.
   3. Curro's CEO, Chris van der Merwe, reiterates its profit promises to the market by indicating that they are expecting a R1m profits at the end of 2011. (See here where vd Merwe says "...we promised the marketplace a profit after tax of R1m at December 31 this year. According to our cash flow and business forecast, we will easily strike that target.")
   4. Curro's CEO, Chris van der Merwe, goes on record talking to Moneyweb as reiterating this strategy of building schools and identifies the target as constructing between 3 and 5 news schools a year. (See here where vd Merwe specifically says that "The business vision, Hilton, is to construct anything between three to five schools per year.")
   5. Curro then buys Woodhill College for R185m (over 10% of Curro's market cap at that stage.) on 22 November 2011, just about five months after being listed. CEO, vd Merwe, talks to Moneyweb about the acquisition and goes on record saying the following: "...we have two different growth divisions in our company. The one is by naturally enrolling children and the other one is by acquiring schools ...  Alec, unfortunately I can’t share our new vision with you, we can do that after December."
   6. Curro CEO, vd Merwe, then goes on record again a couple days after this when talking to Summit TV by saying that Curro's "...integral strategy is always to build."
   7. Curro then buys three more private schools in late February and, while talking to Moneyweb again, CEO vd Merwe states how "...we have revisited our vision and in terms of our strategic intent we now focus on three key words. So we are spreading our wings to go for acquisitions of schools similar to Woodhill, so that is a change in vision. Obviously we are going ahead with the developing of Curro original schools because that seems very, very popular, and now we see an even bigger market in terms of entering the school market similar to the Meridian concept."
   8. A day later, Curro then releases a revised trading statement indicating how "Shareholders are hereby advised that a reasonable degree of certainty exists that the Company will report an attributable and headline loss of between 5.6 cents and 6.6 cents per share for the year ended 31 December 2011, opposed to a profit of 0,7 cents per share published in the Profit Forecast."

    

   So basically, Curro came to the market to build private schools and promises some targets, which included a break-even / small profit position by the end of 2011. And Curro then has gone around buying schools and will not make a profit in 2011.

    

   If your competitive advantage is low school fees and these schools fees are low because you have the ability to build cheaper schools than competitors, then how exactly are you achieving this if you are buying schools other businesses built?

    

   So, basically, Curro's competitive advantage comes from building, but they are now buying.

    

   But Curro's "...integral strategy is always to build."?

    

   But, oh, wait... Now Curro has "...revisited [their] vision and in terms of [their] strategic intent [they] now focus on ... acquisitions of schools similar to Woodhill ...[and]  developing of Curro original schools ... [and] ... entering the school market similar to the Meridian concept."

    

   And forget about the 2011 profit, now Curro's going to report a loss because it has "...subsequently built additional capacity and seized more opportunities than initially anticipated. The costs associated with same have consequently had a negative impact on earnings during the current reporting period."

    

   Wow, sounds fantastic... Fantastic for everyone, except those minority shareholders who put their hard earned cash into Curro stock based on its pre-listing statement and related strategy.

    

   In the meantime, "Curro's prospects remain positive and the financial benefits associated with the expansion of the Company's footprint are expected to come to fruition in upcoming reporting periods."

    

   So a lot of what you previously said has not come to pass, but because you tell us that everything is great we must be happy with that..?

    

   The problem with Curro's growing divergence between its promises and reality is that it has not even been listed for a full year! So with such early stage divergence, it is anyone's guess what Curro will be doing in five or ten years time?

    

   If I make a long-term investment into Curro, then I have to be certain that what I am investing in, is actually what will be there in five or ten years time.

    

   At this rate and within a reasonable margin of forecast error, I am just not convinced anymore that I know what Curro will look like in five or ten years time.

2. South Africa's Unit Trust Industry Growth

   This is a graph of the unit trust industry's assets under management (AUM) since 1992 until the latest (Q4:11) quarterly disclosure:

    

   (Click to enlarge in a new window.)

   

    

   Not just has the South African unit trust industry grown over the last two decades, but, if you look at the regression line, the industry's AUM has actually grown exponentially.

    

   Let me try some new here. You will have seen that I have enabled comments on this website.

    

   Well, let's use them...

    

   Why do you think the AUM of the unit trust industry has grown exponentially over the last two decades?

    

   And, do you think this growth will continue for the next two decades?

3. MTL Delisting, SVB and SUR Trading Updates

   Mercantile Bank (MTL) has long been too small to be listed, too tightly held to be traded and too under-performing to really care. Earlier this year, the Bank issued a cautionary announcement indicating how it's Portugese parent was considering buying out minorities and delisting the Bank.

    

   This comes shortly after a failed bid by Bidvest for the Bank Bidvest Bidding for Mercantile Bank) probably rattled some Mercantile ExCo and its Portuguese parent's cage a bit.

    

   Late yesterday, Mercantile released an announcement detailing an offer to buy out its minorities at 52cps in cash.

    

   Mercantile's share price was drifting just below 40c the day before and jumped up to close yesterday at 48c. This over 20% rise in MTL's share price has left a little over 8% arbitrage opportunity on the table, but the problem is that investors now buying at 48c may have to wait for quite a while to get the necessary approval and the final payout.

    

   Not just event risk of a takeover/delisting bid failing, but also actually the time value of money is also built into these types of arbitrages.

    

   Personally, I see quite a number of other opportunities in the market and would leave the 8% on the table, take my money and shift it into stocks that currently have more upside than MTL's capped 8%. Either way, though, if I waited, I would accept the offer on the table of 52c (which is very generous compared to Bidvest's offer of 35.5cps for each MTL share!).

    

   Moving onto two positive trading updates, Spur Corp (SUR) and SilverBridge (SVB).

    

   Silverbridge is a niche software group servicing the financial services, insurance and related industries with most of its own IP and products. The Group has just announced that it expects its EPS to be between 5.6cps and 6.3cps and HEPS is expected to be between 5.8cpss and 6.5cps.

    

   This is extremely good news for the micro-cap, as in the previous reporting period some implementation problems saw it report a nasty little loss.

    

   In a nutshell, using the DCF Model (and my 'rule of thumb' benchmark Cost of Equity of 15%) I arrive at a rough fair value of 144cps.

    

   While capex is relatively low in SilverBridge, the Group has to spend a large amount of money on R&D for Exergy (and related), thus this creates quite a draw down on free cash flow in the Group that negatively impacts the DCF’s free cash flows. If this R&D is excluded from the DCF, then the SVB’s NPV almost doubles.

    

   Bear in mind that a lot of this R&D is capitalized on the Group’s balance sheet and amortized through the Group’s income statement over time, thus making profits look higher the related cash flows and, perhaps, making SVB look better than it really is when only profits are viewed and not cash flows. In other words, SVB's PE ratio will be lower than if it were calculated on a cash-basis.

    

    

   An extrapolated 12m TP for SilverBridge would be 165cps or implying a total return of 15% with SVB’s current share price of 144cps.

    

   Unfortunately, in my opinion, 15% upside is simply not enough to go on for the SVB’s risks (which include an over concentration of IP in certain key individuals in the Group!) and shares almost complete absence of liquidity in the market.

    

   Still, given SVB’s strong in-house IP and its sizable majority shareholders, this does potentially make the Group a delisting candidate (being an MBO, LBO or even a private equity deal). Perhaps, like Mercantile mentioned above, an offer to minorities may one day appear?

    

    

   Finally, Spur Corp (SUR) indicated that it expects its H1:12 EPS and HEPS to increase by between 18% to 22%.

    

   Sounds good, doesn't it?

    

   Well, let me visually represent something for you: Famous Brands' (FBR) RoE versus Spur's (SUR) RoE over time.

    

   

    

   

    

   Famous Brands is increasing in profitability, while Spur is decreasing.

    

   Various share repurchase effects, once-off cost non-re-occurrence and some revenue growth all are the likely culprits for Spur's trading update (we will know more on 27 February when the results come out), while Famous Brand's is all about top-line growth and returns to scale.

4. Comair, Topfix & Italtile

   Comair (COM) reported its H1:12 results for the interim period ended December 2011. The airlines Group had previously issued a profit warning indicating a coming loss (see - SUR, COM & FGL and a little more background here 1Time & Comair Will Hurt).

    

   Comair's revenues actually grew 17% to just a little more than R2bn on higher fleet utilisation and the larger Boeing 737-800 aircraft introduced last year. Unfortunately this was simply not enough to offset higher average fuel prices (+41% in the period) and higher airports tariffs (+70% during the period). The latter constrained Comair's ability to pass on costs to passengers, thus went a far way in pushing the Group into a HEPS of -4,9cps (H1:11 - HEPS of +10.3cps).

    

   Comair remains very cash generative, though, and both generated Cash from Operations (and investment income) of R161m (H1:11 - R34m) to end the year with a cash balance up some R20m to R254m (FY 11: R234m).

    

   The Group's balance sheet also retains quite robust with a NAV per share of 159.6cps against a share price of 151cps. There is very little goodwill or nasty intangibles on the balance sheet either.

    

   Finally, it is worth noting that the Group's "Non-airline" revenues actually grew c.270% during the period to R122m (H1:11 - R33m) and significantly hiked its profits to R15m (H1:11 - R10).

    

   I strongly suspect that this "non-airline" segment is not just the future of Comair, but the future of the entire airlines industry, as eventually the airlines industry will become a break-even industry that generates profits from its captive client-base (once you are in the airport, on the plane or looking at their website) and from support and related services (aircraft maintenance, pilot training, etc.).

    

   Comair is quite negative about its prospects and goes on to say how the directors "...remain of the opinion that the high oil price and a weak global economy will prevail for the foreseeable future."

    

   Moving on, Italtile (ITE) is a fantastic business. It really is. It has a great balance of variable costs that allows it to maintain (and even grow!) profits during construction and building sector slow downs while standing to benefit from the upswings too. My view is that this is mostly based on Italtile's non-investment in manufacturing capacity (which would have been a fixed costs and made them volume dependent) and their sourcing/importing of tiles and product from where ever suits them best (which is a variable cost).

    

   Compare this to Dawn (DAW), which operates in most of the same markets as Italtile, but made the "strategic" decision to backward integrate its operations in order to capture manufacturing margins upstream. This basically saw Dawn's results become highly volatile from their dependence on manufacturing volumes that eventually resulted in Dawn reporting a nasty little loss in FY 11. Italtile reported a c.5% increase in HEPS over this period.

    

   Well, more recently, Dawn has just reported a trading statement indicating that it expects its HEPS for H1:12 to up between 30% and 35% due to "...improved results from the Infrastructure segment of the Group."

    

   Italtile just released their H1:12 results and shows a 22% rise in HEPS to 21,7cps (H1:11 - 17,6cps).

    

   Personally, I would rather have slightly lower profit growth that is more consistent in performance and result, than wild swings in profitability and the underlying uncertainty and risk that naturally follows that.

    

   Hence, I prefer Italtile to Dawn.

    

   Finally, Topfix (TFX), has just announced the resignation of its CEO, Benjamin Marais, and the simultaneous sale of Top Fix Scaffolding (Pty) Ltd (TFS) and MBM Administration & Labour Brokers (Pty) Ltd (MBM) to him for the equivalent of 48million TFX shares and R5m cash (or, c.R29m in amount).

    

   The rationale for the disposal is as follows: "The board has decided to dispose of TFS and MBM as part of its strategy to decrease its exposure to cyclical industries such as the construction industry and to increase its focus on the personnel outsourcing, personnel placements and safety services industries."

    

   That is all nice and well, but the deal disposes of a major asset of Topfix's, it disposes of the said asset to the former CEO (a related party), the former CEO remains the major shareholder in Topfix (even more of an influential insider!), and the former CEO is leaving with the said assets.

    

   I am not comfortable with this at all and, if I was a Topfix shareholder, I would be kicking up a fuss.

    

   Here are the two pertinent questions I see:

    

   If the assets are worth getting rid of, why is the Former CEO going with them and not staying the CEO of the "improved" listed Group?

    

   If the listed Group is improved after disposing of the TFS and MBM businesses, why is the former CEO effectively dis-investing a large portion of his shareholding (c.88% of his shareholding of c.54million TFX shares are being effectively "exited") in the listed Group? Surely, he would like to retain the shares in TFX, if TFX is going places, that is...

    

   Like I said, if I was a Topfix shareholder, I would be kicking up a fuss.

5. Trading Updates: AFE, OLG and BFS

   Three small cap trading updates came out late Friday last week and, actually, they were all quite positive.

    

   Manufacturing and mining chemicals and support services group, A E C I Ltd (AFE), indicated that its FY 11 EPS are expected to be 27% to 32% higher than last year. HEPS will also be up between 22% and 27% on last year.

   
   AECI earns over half its revenues from specialty chemicals and just under half it revenues from mining services. The Group sells into the mining sector (explosives and related services by AEL, found here) and in the specialty chemicals cluster it has 18 business units supply specialty chemical raw materials and related services for industrial use across a broad spectrum of customers, seemingly mostly also mining and manufacturing in South Africa and southern Africa.

    

   What is interesting about AECI is that it historically has held a large amount of land on its balance sheet. Why? Well, dynamite needs space (lots of it) to manufacture and test... But there are other legacy reasons for the non-core land holdings. Thus, the Group initiated a project to realize these real estate assets a number of years ago and the Group is going about slowly turning over the property portfolio or developing it and leasing it out.

    

   For this reason AECI's profits are distorted by period where a large or a couple large property sales go through and those when nothing do. But, unfortunately, my understand is that as the property segment's business is that of, well, property, IFRS dictates that its profits (and losses) cannot be excluded from Headline Earnings. Thus, HEPS is also distorted by these property activities.

    

   So, basically, while AECI's trading statement is positive, bear in mind the distortion by the property segment. Still, if AECI's previous reporting period is anything to go by, the core mining services and chemicals businesses in the Group must be doing quite well.

    

   Also glancing at a fairly cyclical stock, Onelogix (OLG), released a trading statement indicating that H1:12 profits, EPS and HEPS should be up between 15% and 20%. See my previous article on OLG here: RGT, MOR, OLG & DCT.

    

   While Onelogix has PostNet in its stable, the Group's swings in profits (upside and downside) really come from its VDS and CVDS subsidiaries that deliver new vehicles all over southern Africa. VDS and CVDS have a large slice of this new vehicles delivery market.

    

   New vehicles are delivered to dealers and various other businesses, thus deliveries of VDS and CVDS is a leading indicator of new vehicles sales.

    

   New vehicles sales is a leading indicator of the general economy.

    

   So, (assuming the above new is relating to VDS and CVDS and it is based on a growth in revenues of these businesses) Onelogix's trading statement is probably quite a nice positive for South Africa and the broader stocks that are highly exposed to our local economy.

    

   Finally, Blue Financial Services (BFS), released a trading statement indicating that it is reasonably certain that it will earn between 0.35cps and 1.12cps EPS for FY 12 (ending 29 February 2012).

    

   See an earlier article Blue Financial Services here: BFS & ADW Trading Updates & Comparison and a slightly earlier thought over here: Is Blue Financial Services Turnaround Working?.

    

   Blue's trading statement goes into a couple of reasons for the turnaround in profits, but most importantly is mentions that H2:12 saw continued momentum in its objectives of cost-savings and collections of debt. The coming financial year will be a key on in whether Blue can shift its focus from internal cost-savings to external loan book growth and whether it can achieve this profitably, net of bad debts and back office cost-escalation.

    

   We will see...