How would one make money from the boom in air travel? Is the answer to invest in airlines? It sure looks like it in recent times as Warren Buffett, the Oracle of Omaha, has invested in multiple US airlines. However, one would do well to remember the timeless quote from Richard Branson – “If you want to be a millionaire, start with a billion dollars and launch a new airline”. Airline is notorious for its low returns per capex dollar spent. When an airline invests in new aircrafts, competitors would have to do the same in order to keep up. However, because competition is fierce, there is very little pricing power for airlines. All this results in a boon for consumers but very little benefit to the airlines.
A better avenue, I believe, is to look at an auxiliary business for airlines — aircraft leasing. The aircraft leasing business has high barriers of entry due to the significant financial muscle required and this has resulted in few global players. One of these global players is Aercap (NYSE:AER) which was listed in 2006. Since listing, it has grown book value impressively from $USD 8.83 to $USD 50 as of 2016. In 2013, it acquired AIG’s ILFC to become the largest independent aircraft lessor globally.
On a high level, aircraft lessors such as AER, borrow money from the financial markets to purchase planes from manufacturers and lease out these planes to airlines in return for monthly lease payments. Put it simply, AER is profitable when net interest margin is over and above all outgoings. AER currently trades at less than $USD 46 per share with FY 2016 EPS at $USD 5.52. Management has guided FY2017 EPS to be $USD 5.7 which gives AER a forward P/E ratio of around 8. From a valuation perspective, AER looks like a no-brainer.
One aspect of the business that may trip up investors is the amount of debt that AER carries — $USD 28B as of FY 2016. Should one be concerned by this? On face value, the debt to equity ratio of 2.7x may look distressing but the ratio that we should be looking at for a finance company should be the equity/asset ratio. AER’s equity/asset ratio is at 20% which shows that it is conservatively geared. Therefore, I do not concern myself with AER’s debt for my evaluation of the company. Before you get your panties in a knot, think of it this way — the interest expense on debt for AER is a cost of sales and with a 20% operating margin, AER will make a profit of 20 cents for every dollar it borrows to purchase an aircraft and lease it out. If this isn’t making money hand over fist, I don’t know what is.
A few other plus points from the earnings call – AER has obtained an investment grade credit rating from Moody’s which should bring down its borrowing costs. Also, AER board has authorised a $USD 350M share buyback which will run till 30 June 2017. Bearing in mind with a current market cap of $USD 9B, that is about 4% of the shares that could potentially be bought back.
My next post will be on Select Harvest (ASX: SHV) after it has reported earnings for HY2017.
A truly value investor should always sniff out value stocks regardless of the form. Essentially, this means looking for underpriced stocks in different sectors, different countries, yield vs growth etc. You get the drift — basically under every rock. This would particularly ring true for any Australian investors. Any trade in Australian equities would most probably be a crowded trade. If you don’t believe me, just check out your default option in your superannuation and it will be heavily weighted to Australian shares. The slush of cash flowing into superannuation which subsequent gets pumped into Australian equities results in immense bidding for a small pool of quality Australian companies. Therefore, I see great benefits in investing in international shares.
For any potential converts, there are several ways to invest internationally. One avenue is to use Australian brokers but the commission costs are unnecessarily high and will eat into your profits (especially if your investment amount is small). Another way is to use an international broker such as Interactive Brokers which has more reasonable pricing. The last avenue that I can think of is to invest international via contracts for difference (CFDs). Full disclosure, I have investment interests in two CFD providers i.e. IG Markets and CMC Markets but I don’t imagine having enough sway via viewership numbers to make a difference. The payoff profile when investing in a CFD of a certain company is largely similar to investing in its shares except for franking credits. Also, CFD allows one to apply leverage but this can be a double-edged sword i.e. both gains and losses are amplified.
All of this babbling brings me to the main focus of this post. General Motors (NYSE: GM) and Michael Kors (NYSE: KORS) had just received their latest earnings on the 7 February 2017 and both suffered significant drop in their share price.
GM is the largest automobile manufacturer in the USA. Brands under its umbrella include Buick, Cadillac, Chevrolet & GMC brands in the USA and the Buick, Cadillac, Chevrolet, GMC, Holden, Opel & Vauxhall brands outside of the USA. Analysing GM is simply a numbers game. GM is extremely cheap with a share price of $35 USD and management guided earnings of $6-6.5 USD which gives it a P/E ratio of less than 6X. GM pays out $0.38 USD of dividend per quarter which gives it a dividend yield of 4.5%. It has also $10B USD worth of share buyback remaining and with a market capitalisation of $54B USD, that would equate to a buyback of approximately 20% of its shares. Critics have been ranting on about ‘peak auto’ for some time and has so far been incorrect with 2016 numbers coming in at 17.6M cars sold (2015: 17.5M) .
With a dividend payout ratio of just 25%, GM would still be able to sustain its dividend if America’s new car sales crash and GM’s profits were to collapse by 50%. Its latest earnings results prompted a 5% decrease in share price even when it topped estimates. Sometimes, similar to God, Wall Street works in mysterious ways. I can only assume that the decline in price is due to profit taking because of the YTD run up in share price.
KORS is a semi-premium brand best known for its women handbags. It has seen its share price decline from a high of $98 USD to a current $38 USD which is near to its 52 week low. It is a serial buyer of its own shares with management (and I) believing that its share price is severely undervalued compared to its competitors. Since the inception of the share buyback program in 2014, it has since bought back $2.5B USD worth of shares. Compared to its market capitalisation of $5.5B USD, this is significant.
Like most retailers everywhere else, KORS is facing some headwinds and its share price has crashed by 11% since the latest earnings result. It has seen less mall traffic and its wholesale channel is aggressively discounting its products. To counter this, KORS is pulling its products from the wholesale channel and embarking on growth initiatives like selling smartwatches and increasing its presence into menswear. According to the latest earnings call, management is currently looking at M&A opportunities and other capital initiatives. Its main competitors are Coach (NYSE: COH) and Kate Spade (NYSE: KATE) and both companies has higher valuation than KORS despite lower earnings. With the P/E ratios of COH and KATE at 21x and 19x respectively, KORS looks extremely undervalued at 9x. It should be noted that, unlike COH with a dividend yield of 3.6%, KORS does not pay a dividend but instead focuses on share buybacks. I reckon KORS would be trading at a higher multiple if it introduces a decent dividend in the future.
Added Collection House Group (ASX: CLH) and Credit Corp (ASX: CCP) to watchlist
Have you ever faced a moment of “damned if I do and damned if I don’t” with respects to equities investing? I am currently in such a conundrum on whether to take a plunge into the debt collection business. The major listed players in Australia are Credit Corp (ASX: CCP), Collection House Group (ASX: CLH) and Pioneer Credit Limited (ASX: PNC). In a general sense, debt collection is a straightforward business — these companies purchase delinquent receivables from various clients e.g. banks, utilities companies etc and aim to collect more from these receivables than what they purchase for. These receivables, or otherwise known as purchased debt ledgers (PDLs), are generally purchased for 5 to 20 cents on the dollar although in current times, it is closer to the top range due to pricing pressure. Because of its business model, certain debt collectors like CCP are able to produce impressive financial ratios such as ROE and profit margin in excess of 20% for FY16. All these factors has unsurprisingly piqued my interest in this sector.
However, it is the same business model which is a source of indecisiveness for me. In its purest form, debt collection companies are essentially an outsourcing avenue for companies. Companies which has uncollectible debts may ‘outsource’ the collection of these debts for a fee. In the case of a company selling receivables 20 cents on the dollar, the fee is essentially 80 cents of every dollar. When debt collectors contacts customers of these PDLs, they give the general impression of acting on behalf of the ‘outsourcers’. Depending on how the debt collectors act, there may be reputations risk for these companies e.g. a threatening and pushy debt collector may harm the reputation of the company that sold the PDLs. Consequently, some companies have taken their debt collection in-house. If enough companies do that, it may result in a structural change in the industry where there are not enough PDLs to go around and remaining PDLs are bid to an uneconomical price.
More importantly, I see some potential issues in revenue recognition of the debt collectors. Accounting standards dictate that revenue should be recognised on an accrual basis instead of a cash basis. Therefore, revenue derived from PDL for these companies are calculated based on an effective interest rate (EIR) and does not actually reflect the actual amount that is collected from the PDLs. EIR is an interest rate derived from the purchase price of PDLs and the amount that the debt collection company is expected to recover from the PDLs. This opens up an incentive for management to distort short term earnings by making overly optimistic assumptions and bringing forward earnings and impairing and recognising a loss in the later life of the PDLs. Additionally, because of the use of EIR for revenue recognition, it is always in these companies interest to purchase as many PDLs as possible with little regards to the cost and the credit risk it poses.
Enough of me rambling and have a look at actual companies. As the title of this post suggest, the focus is on Collection House Group (ASX: CLH) and Credit Corp (ASX: CCP). CCP and CLH are the first and second largest (measured by market capitalisation) listed debt collection companies respectively. CCP and CLH have the same business bar an exception – CCP has an addition (subprime) lending business which should not be confused with payday lending. The table below shows some financial ratios and statistics for the two companies:
As it can be seen, CCP deserves a higher valuation due to its better metrics. Also, CCP is deemed to have a more diverse business with part of its operations in the US and its foray in subprime lending. However, despite this, I prefer CLH as an investment. Don’t get me wrong, there is nothing awful wrong for CCP. However, I prefer an underdog, and, in terms of valuation, the bar is set much lower for CLH. Also, there are positive steps currently undertaken by the new CEO of CLH, Anthony Rivas. CLH has secured a 5 year collection contract from a major ASX client and Anthony Rivas is looking to boost collection staff productivity from the current $166/hour for FY16 to $195-$205/hour for FY17.
At the Awkward Investor, our portfolio will always be of a concentrated nature. I see no value in making investments just for the sake of diversification. We are near full investment and therefore I will be adding both CCP and CLH to my watchlist.
Initiated a position in Nine Entertainment Holdings (ASX: NEC) with average price of $1.06 AUD
Added to CMC Markets with a current average price of 110.76GBX
Added to Seven West Media (ASX: SWM) with a current average price of $0.8 AUD
Added Shriro Holdings Limited (ASX: SHM) to watchlist
I do not believe that the FTA industry is in a death spiral and have initiated a meaningful position in Nine Entertainment. I came across NEC while researching Seven West Media and was impressed by their shareholder friendliness. It has recently sold Nine Live which is their events business to a private equity and has greatly reduced their debt from 600M to 200M and recently completed a share-buyback. If you ever need validation of your investment, look to the major shareholder list. Allan Gray, a deep value fund, owns 10% of NEC – do I need to say more? An issue which I cannot get my head around is why NEC is more highly valued than SWM by Mr Market despite SWM being the market leader in FTA? Some possible reasons that I can think of are that SWM has higher debt and that Kerry Stokes owns majority of SWM. The latter is important as minority shareholders may be given the shaft depending on what Kerry Stokes does.
Any astute readers of my website would notice a religious pattern to my stock selection — the preference for beaten down stocks with low P/E ratio and sound business fundamentals. Therefore, one should not be surprised that my analysis today is on Shriro Holdings Limited (ASX: SHM).
SHM is a distributor of kitchen appliances and certain consumer products. The Kitchen Appliances division include company-owned brands (e.g. Omega) and third party brands (Blanco). Ditto for the Consumer Products division, with company-owned brands such as Everdue and third party brands such as Casio. SHM executed an IPO in 2015 at $1 AUD and is currently at $1.17 AUD. Its trailing P/E ratio is an undemanding 8.5X and it distributed a full franked dividend of 6 cents for FY15. These statistics would be enough to whet any value investor’s appetite and it has rightly done so for me. However, I will further detail below on why I am reluctant to pull the trigger as yet.
Right, let’s get the pros out of the way. Low P/E ratio, high divided yield and manageable debt (i.e. 9M on 120M of market capitalisation). The business is easy to understand and its performance is partly tied to the construction of new houses which is currently booming in the two biggest cities in Australia i.e. Sydney and Melbourne. SHM has a policy of paying 60%-70% of NPAT as dividend and management has guided that NPAT for FY16 would be modestly higher than FY15 of $12.4M AUD. SHM has also embarked on new products such as a BBQ range with celebrity chef Heston Blumenthal and the Neil Perry Kitchen.
Now to the fun stuff. The general consensus for SHM’s low P/E ratio is that it’s fortunes are too intricately tied to the housing market. Putting it another way, the housing market is a double-edged sword for SHM. On one hand, the boom in Australia’s new built houses has greatly boosted its bottomline but a low P/E is justified for SHM because the perception of a housing bubble in Australia. I am not going into the futile debate of whether Australia is in a housing bubble right now because I believe the debate will never have a conclusion. Only time and the benefit of hindsight will tell if we are in a housing bubble now.
However, my concern is not so much with SHM’s exposure to the new home starts. According to the annual report for FY15, out of EBITDA of 22M, the Kitchen Appliances division only contributes 6M of it. What concerns me is the remaining 17M of EBITDA which relates to the Consumer Products division. One of the mainstays of this division is Casio which is a third party brand. SHM has no formal agreement with Casio which means that Casio can terminate this relationship as it sees fit. Management does not provide how much revenue is attributed to Casio but judging from Casio prominence in the prospectus and FY15 annual report, I am willing to bet that it is significant. If the relationship with Casio is terminated, potentially a large portion of 17M could be wiped out.
Also, the FY16 interim results reveal that revenue from the Kitchen Appliances division dropped 13.7% YoY as a result of loss of sales channel for Blanco appliances. Specifically, Harvey Norman retail and The Good Guys has stopped carrying Blanco products. Management has indicated that the shortfall will be caught up in the second half of FY16 once a new sales channel is found. On face value, this sounds like non-issue but let’s do a little of ‘inverted thinking’. If Blanco is profitable for Harvey Norman Retail and The Good Guys, would they stop carrying the Blanco appliances range? One can only conclude that Blanco is underperforming for Harvey Norman and The Good Guys. Blanco is the default kitchen appliance e.g. oven for many of the new built houses and anyone that has recently built or purchased a new house could attest to their undesirable quality. Management has provided updates that Bunnings will now carry the Blanco kitchen appliances range. However, I am not hopeful that they will be able to claw back lost sales in the H1 of FY16.
In addition to that, buried deep in Section 9.4 of SHM’s IPO prospectus is the onerous nature of the contract with Blanco. This includes a clause which allows Blanco to terminate with a 12 months notice whereas the notice period for Shriro is 5 years. Also, under the distribution contract, Shiro must not sell or promote any similar products in competition with licensed products manufactured by Blanco. Does this seem fair to anyone? This essentially means that SHM would have to distribute Blanco products no matter what happens.
Maybe some readers may judge me to be too paranoid in listing the above concerns. However, I believe that the hallmark of being a value investor is the protection of capital. It is not the fear of missing out on potential profits that should drive a value investor but the fear of losing money. Having said that, I am not writing off SHM as an investment. It will be in my watchlist until the contract situation has been resolved or the share price has come down to a point where there is immense value. One can only hope….