ARB Holdings – Good Story in a Tough Market

Initiation of Coverage – Share Code: ARH – Market Cap: R1.4bn – PE: 12.7x – DY: 2.2%

Download the full ARB Holdings Initiation of Coverage Report Here

Business Overview: Market, Store and Product Expansion

ARB has built a scalable electrical products distribution and wholesaling business off the back of a core cable product supply with key growth drivers being the expansion in product lines, movement into new territories, markets and industries and selected strategic bolt-on acquisitions.
The Electrical Division is predominantly a wholesaler of cables, overhead lines and related electrical components in Southern Africa.
In mid-FY 12 ARB Holdings acquired a 60%-stake in Eurolux (Pty) Ltd, a fast growing importer and distributor of light fittings, lamps and ancillary electrical products.
The Group Services segment includes the strategic and operational activities as well as holding the underlying property portfolio of the Group with a book value of R163m.

Key Issues: Macro-economic Variables Worrying

With many frothy indicators, the construction, building and related market in South Africa has many short-term downside risks including the current labour environment, the rising interest rate cycle and the upcoming elections.
Despite this, South Africa’s infrastructure needs are significant as encapsulated in the National Development Plan (budgeted c.R827bn spend) and the building materials market stands to benefit handsomely from this (eventual) roll-out.

Forecast, Valuation and Implied Return: Attractively Priced

Our fair value for ARH is 622cps on a PE of 13.5x. Rolling this forward at our Cost of Equity (CoE), we arrive at a 12 month Target Price (TP) of 727cps on an Exit PE of 12.7x implying a return of 21% from the current levels.
The two key risks to our above valuation methodologies are (1) the major macro-economic variables in South Africa (noted above), and (2) the timing and successful implementation of ARB’s product, store and market expansion drive (including any potential future acquisitions).

Download the full ARB Holdings Initiation of Coverage Report Here

What do you think of ARB Holding? Let us know…

See our methodology here and note our disclaimer here.

Accentuate – H1:14 Results – Tough Trading Period

H1:14 Results Note – Share Code: ACE – Market Cap: R73m – PE: 11.3x – DY: 0.0%

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H1:14 Results: Tough Trading Period, Hampered by Weak Rand & December

Accéntuate reported disappointing H1:14 results that saw sales rise 7% to R157m (H1:13 – R146m), but margins compress and Operating Expenses rise by c.13%. The rise in opex was partly due to Suntups duplicate leasing costs (eventually this business will moved into existing Group premises) and distribution costs being passed onto the Group by the higher diesel price.
This culminated in profit attributable to shareholders falling c.49%, HEPS being reported below our expectations at 2.81cps (H1:14 – 6.01cps).
Two small acquisitions were made during the period, being Suntups (wooden flooring) and Degrachem (metal treatment chemicals).

Our Thoughts: Promising Start to H2:14E

Floorworx saw a particularly tough December 2013 that appears to have reversed during January 2014, but the volatile Rand has affected most its businesses units negatively in the short-term.
In the long-term, though, the weak Rand creates a massive competitive advantage for the Group’s East London manufacturing asset (key in Floorworx) that positions the business well for the (very) slow recovery in some key indicators in the local construction and infrastructure market continues.
The South African elections (coming early May) create some short-term downside risk, as we believe that public sector spend is likely to be interrupted before, during and after this period.

Forecast, Valuation and Implied Return: Underpinned by Tangible NAV of c.90cps

We lower our fair value to 86cps (previously: 122cps), which is underpinned by ACE’s current TNAV of c.90cps and arrive at a 12m TP of 100cps (previously: 142cps), on an Exit PE of 11.0 (which is arguably inflated due to the trough earnings the Group is trading through currently as well as the fact that Ion Exchange Safic adds to our DCF SOTP but doesn’t add to the Group’s profits at this point).
Our 12m TP of 100cps (previously: 142) implies an attractive 73% return, but note the risks to our view later in this report.

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See our disclaimer.

Wescoal Holdings – H1:14 Results – A Precursor of Prospects

H1:14 Results Note – Share Code: WSL – Market Cap: R374m – PE: 12.0x – DY: 1.3%

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H1:14 Results: Intibane & Higher Coal Price Lift Results

Revenue rose 33% to R466m (H1:13 – R351m), driven mostly by Intibane’s three month contribution and a slightly higher average coal price. Operating leverage lifted EBITDA by 75% and HEPS grew 65% to 11.4cps (H1:13 – 6.9cps).
The Coal Trading segment saw lower volumes squeezing margin and really had quite a dismal trading period. The conclusion of the MacPhail acquisition (still contingent on Competition Commission approval) will likely add significantly to this segment in H2:14E and, especially, FY 15E.
Despite investing c.R51m during the period, the Group was highly cash generative and management sees the potential for further mid-tier coal asset acquisitions as majors continue to dispose of non-core assets from their portfolios.

Our Thoughts: MacPhail Exciting, but Awaiting CompCom Approval

The only outstanding condition for the MacPhail acquisition is the Competition Commission (CompCom) approval.
We have adjusted our forecasts to reflect our anticipated effective date for MacPhail (13 November 2013), assuming the CompCom approves of the deal, and have inserted c.R2m worth of restructuring costs into H2:14 while modelling annual savings of c.R9m being realized from FY 15E onwards.
Downside event risk is if the CompCom does not approve of the merger of Chandler and MacPhail. In this event, our 12m TP would drop by at least c.14cps or c.5%.

Forecast, Valuation and Implied Return: 12m TP Raised 17%

We lift our fair value by 19% to 253cps (previous: 213cps), implying a PE of 15.1x. This PE is not very illustrative, as both Elandspruit and MacPhail are not yet adding to profits.
We raise our 12m TP by 17% to 287cps (previous 12m TP: 246cps), implying a 43% return on an Exit PE of 6.4x.
As Wescoal is a junior miner, we draw your attention to the risks we identify in the body of this report.

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Five Things to Look for in a Turnaround

Turnarounds are risky, but if they work that can often create staggering investment returns as a deeply discounted share rebounds to fair value and, perhaps even, moves into a higher rating as a growth stock as the rest of the market grows in confidence.

But how do you know if a turnaround is going to work?

The short answer is that you don’t know. But, try focusing on the following aspects when analyzing a business for the potential of turnaround prospects:

1.) Solvency: The less debt you have, the more time for the turnaround you get

Debt is a time sensitive funding structure as interest is incurred over time and, particularly in structured debt, have set covenants, repayment schedules and/or redemption details and dates. This include net overdraft positions and even off balance sheet funding (via operating leases and other more “creative” structures).

In other words, the more debt a turnaround business has, the less time it often has to “get things right”. It may be half way to turning the business around when the debt suddenly falls due or the lender calls in its breach of debt covenants, and then–very quickly–the business can hit the wall.

Hence, the less debt a turnaround has, the more time it has to get things right. And the more time a turnaround has, the greater the odds that it will eventually come right.

2.) Liquidity: More cash coming in than going out keeps you in business

Even if a turnaround has no debt, if its operations year after year suck up cash and it never generates any free cash flows, eventually its resources will exhausted and it will need to borrow.

On the hand, the stronger the operating cash flows in a business, the more the business can use these cash resources to shore up other aspects of the business, service debt, payout retrenchments, and so on, in the steady progress towards sustainable profitability.

We would go so far as to say, no matter what IFRS profits are reported, if a company year in and year out produces large operating cash inflows, the business will continue to operate just fine. And, if a business can continue to operate, then it has more time to effect a turnaround and the odds increase that it will eventually come right.

3.) Profitability: Pricing power makes for easier turnarounds

Here is a published an article discussing the major difference between a business’s Gross Profit (GP) margin and its Operating Profit (OP) margin (Insight into Operating & Gross Margins).

In essence, a high GP margin implies a business that has a strong competitive advantage, particularly with regards to its pricing power in its good and/or service. OP margin is more a metric reflecting efficiency, returns to scale and/or “bloat” in a business’s operating structure.

We believe that it is always easier (i.e. improves the odds of successfully) turning around a business that has pricing power, rather than one that is a price taker.

4.) Turnaround plan: A bad plan is better than nothing, but a good plan is the best

Has the business even admitted that it is doing a turnaround? This may sound like a funny question to ask, but some business’s management are in such denial about what a bad business they are running that they cannot admit that they are trying a turnaround, and thus will likely fail. Avoid these.

Then next level is that, at least, management admits that it is performing a turnaround. That goes hand-in-hand with having a “Plan” for the turnaround.

Consider whether the Plan is a good one, though? Be particularly skeptical when it is the same management that originally ran the business into the ground that are suddenly offering this Plan as a solution… If they messed up once, the odds are increased that they will do so again in the future.

Does the Plan admit what went wrong? Does the Plan state what needs to be done to address what went wrong? Does the Plan cover all bases and does it sound reasonable to you?

Not all plans are good plans, but having a plan is better than nothing.

5.) Management: Are they committed and convinced?

This last point is actually tied into (4) above, as management are the ones who draft the Plan and have to execute the Plan.

Only with hindsight will we know if the execution of the Plan is actually good or not, as investing into a turnaround is investing before the Plan becomes reality. So, try to get a sense for whether management will execute the Plan well or not, but it will remain a guess at this stage.

Rather, consider if management are committed. Have they bought large amounts of their own stock? Are they large shareholders in their own turnaround? Have they underwritten their rights issues? Have they signed multi-year employment contracts?

If management has no skin in the game regarding the turnaround, the odds are that they are not convinced that it will succeed.

In conclusion, each turnaround really actually needs to be judged on a case by case basis. But, this list should at least give you a starting point from which to try gauge what the odds are for success. And, have no illusions, turnarounds are just like any other investment: they have odds that they will succeed, just as they have odds that they won’t.

Accéntuate Ltd: FY 13 Results – Tough H2, Prospects Remain Good

Initiation of Coverage – Share Code: ACE – Market Cap: R102m – PE: 10.9x – DY: 0.0%

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FY 13 Results: Inland Market Tough in H2:13; Acquisitions Made

Accéntuate experienced a much tougher H2:13 than we had expected. FY 13 revenue flattened to R284m (FY 12: R283m), c.4% shy of our expected turnover mark.
This soft performance during H2:13 comes from Floorworx where particularly the inland market struggled. Safic and Ion Exchange Safic performed in line with our expectations as the former grows its market exposures and the latter continues to build traction in the local market.
The Group’s FY 13 EPS rose 17% to 8.4cps (FY 12: 7.2cps), but critically the HEPS from Continuing Operations slipped 11% to 8.4cps (FY 12: 9.5cps).
Some of this balance sheet was employed post-results to cleverly acquire two small complementary businesses, both paid out in script and to be incorporated from 1 September 2013 (i.e. ten of the twelve months of FY 14E).

Our Thoughts: “When”, Not So Much “If”…

Disappointing results and acquisitions aside, Accéntuate still remains well positioned to benefit from the pent-up public sector infrastructure spend. That said, the 2014 elections potentially create downside risk regarding the timing thereof.
In the meantime, management has been driving growth initiatives into other markets and product lines, and seeking strategic acquisitions.

Forecast, Valuation and Implied Return: Small Upgrade

We raise our fair value for Accéntuate to 122cps (previously: 114cps), which implies a PE of 14.6x. This compares reasonably attractively to two listed comparatives, Distribution and Warehousing Network Ltd (Share code: DAW – PE of 15.3x) and Afrimat Ltd (Share code: AFT – PE of 14.8x).
Rolling our fair value forward by the Cost of Equity (CoE), we arrive at a 12m TP of 142cps (previously: 132cps), implying an Exit PE of 13.8x and an attractive implied return of 54%.
The key risks we see in our valuation of Accéntuate remain macro.

* Note that the Group remains under cautionary announcement pending the release of pro-forma financial results relating to the Suntups acquisition. This results note does not take into account any material information following the resolution of this cautionary announcement.

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Wescoal: An Overlooked Coal Junior With Exciting Prospects

Initiation of Coverage – Share Code: WSL – Market Cap: R239m – PE: 11.1x – DY: 2.2%

Download Wescoal Holdings Initiation of Coverage Report Here

Business Overview: Coal Miner with Strong Coal Trading Operations

Built out of long-established coal-trading operations, Wescoal has moved into thermal coal mining for supply to Eskom.
The Group has built a portfolio of valuable short- to medium-life coal deposits that are mostly either in or near to production.
Khanyisa was previously the only producing mine, but Intibane began production during June 2013 and will contribute to FY 14E. The larger, longer-life mine, Elandspruit, is planned for FY 15E.
The Group has also recently conditionally acquired a large competitor in the coal trading space.

Key Issues: Inland Coal Price and Inland Coal Market Dynamics

The inland coal tends to track international coal prices, which have been under short-term spot pressure as softer global markets attempt to absorb increasing USA exports.
A looming 2015 supply deficit to Eskom creates risks of regulatory intervention in South Africa’s inland coal market.

Forecast, Valuation and Implied Return: Highly Sensitive to Coal Price

Our forecasts are heavily influenced by the assumptions underpinning the timing, efficiency and rate of Wescoal’s new coal mines; critically, Intibane in the short term (from FY 14E) and Elandspruit in the medium term (from FY 15E).
Our SOTPs on Wescoal arrives at a fair value of R367m or 213cps, 54% more than the current share price on an implied PE of 18.6x of historical earnings. This implies a fair value of c.R10 per ton of in situ coal for the Group’s mining assets (c.218cps per WSL share) with a further R56m or 33cps fair value from the Group’s Coal Trading segment. We have taken out a 20% Group discount for overheads and corporate costs.
Rolling forward all the fair values at our Cost of Equity (19.2%), we arrive at our 12m TP of 246cps for Wescoal on an Exit PE of 10.6x, implying an attractive 78% return.
As a junior coal miner, our valuation of Wescoal is based on the assumption of a flat spot coal price. A sensitivity analysis of our models sees our fair value changing by between 10cps to 13cps for every 1% change in the assumed coal price.

Download Wescoal Holdings Initiation of Coverage Report Here

What do you think of Wescoal? Please send us a mail with your view of the Group…

See our methodology here and note our disclaimer here.

Five Lessons with Liquidity

Besides all the usual skills and knowledge that goes with investing in stocks, operating in the small cap space forces you to master handling positions in low liquidity stocks.

Here are five rules to help you handle low liquidity stocks:

1. Stretch your time horizon

Low liquidity makes exiting a position in a stock challenging and, often, costly. But, what if you never exited an investment? Suddenly the investment’s lack of liquidity really would not matter to you (or, at least, matter less).

Forever is a long time, though, but this is also work if you take much longer-term perspectives with your investments. This not only allows your gains to far more exponential (i.e. 10-baggers) from which a small liquidity cost of exiting is minor, but it also can lead to situations where you bought into an illiquid stock that re-rates over years, becomes popular and when you sell your position the market’s liquidity is sufficient to barely notice.

For an example of this latter phenomenon, looks at how the Rand-value traded in EOH has steadily grown over the last decade during which the stock re-rated and the share price exponential rose.

2. Buy with a sufficient margin of safety

By their very definition, low liquidity stocks cannot absorb significant volumes of their script being sold in the market. Thus, low liquidity stocks could see their share prices crash for no apparent reason other than one or a couple of random sellers have decided to dump their positions.

You need to be comfortable enough that the investment you have made into the low liquidity stock is sufficiently discounted against its intrinsic value and future prospects that, if the share price halves on a couple of trades, you could not care less. If fact, perhaps you even consider buying more (see (4) below)?

The only way you satisfy this rule is to thoroughly research and understand the company and then diligently value the stock from all angles. If the stock still appears deeply discounted against your valuation(s) of it, you are likely buying it with sufficient margin of safety that the short-term volatility of its share price can be ignored in favour of your (1) long-term time horizon.

3. The bidding spread

The spread between the bid and offer of a stock is called the ‘bidding spread’. Bidding spreads are actually a cost. The wider the spread, the worse the spread is considered and the greater it may cost the investor.

Let me phrase it like this, if the bidding spread of a stock was 5% and you had bought the stock a second ago and were forced to sell it immediately, you would have to take the highest bid. As that bid is 5% below the Offer, thus it is likely 5% below where you bought the stock. In this case, the bidding spread would cost you 5% of your investment.

Now bidding spreads tend to be ludicrously wide in low liquidity stocks, but if (1) your time horizon is sufficiently long and (2) the stock is discounted enough against its valuation and upside potential, then why haggle about a couple of percent in the bidding spread?

Instead of trying to be clever and placing a low bid (where you could save a couple of percent, but also risk missing out on the stock’s upside by never owning it at all), rather simply cross the bidding spread and pick up whatever stock you want (assuming it is available). Why worry about losing 5% on a bidding spread? If you are never in the stock you risk missing out on 5,000% upside!

So, if (1) your time horizon is sufficiently long and (2) the stock is discounted enough against its valuation and upside potential, then you should be comfortable enough about the value of the long-term position in the stock to do this.

4. Averaging up and averaging down

Sometimes the stock is so illiquid that even if you (3) cross the bidding spread, you would not be able to pick up sufficient script (or sufficient script at the prices you are willing to pay for it). In cases like this, building a position can take time, so consider “averaging up” or “averaging down”, depending on which way the stock is moving at the time.

In other words, if the stock is rising, steadily pick up chunks of it raising your average entry price. If the stock is falling, steadily stagger bids lower and lower and pick up more at lower prices, lowering your average entry price.

This needs to judged on a case-by-case basis and is not always appropriate. But if you have done your homework and are comfortable that you are (2) buying the stock with a sufficient margin of safety and (1) have a long-term time horizon, then you are simply using the market mechanisms to your advantage.

5. Absolutely only ever invest cash you do not need

All the rules from (2) to (4) are meaningless if your (1) time horizon is (forced to suddenly become) too short.

While you can buy into a low liquidity stock with all the right intentions of holding it for many, many years, if somethings happens (probably in your personal life) and you become a forced seller of that stock, then all the above rules are meaningless and the low liquidity will likely cost you dearly.

So, only make investments into low liquidity stocks with funds that you are absolutely, positively sure you do not and will not suddenly need.

The article originally appeared on SmallCaps.co.za.

Accéntuate Ltd: Ground Floor and Positioned for Upside

Initiation of Coverage – Share Code: ACE – Market Cap: R94m – PE: 9.5x – DY: 0.0%

Download Accentuate Initiation of Coverage Here

Business Overview: A Group of attractive businesses

Floorworx is the most significant player in the South African resilient flooring market and stands to gain from the National Healthcare Insurance (NHI) driving hospital refurbishments and expansion. In the long term it should benefit from the eventual roll-out of the pent-up infrastructure spend in South Africa.
Safic is an industrial chemical business in the fast-growing chemicals market with strong linkage into and synergies with Floorworx.
Ion Exchange Safic is 40%-held, early-stage (but extremely promising) water treatment solutions business with key backing by its large Indian-listed parent, Ion Exchange India Ltd.
Accéntuate has de-risked its balance sheet, streamlined its various businesses and now begun to focus on growth. NHI spend should help near-term revenues, public sector infrastructure roll-out should drive medium-term revenues and Ion Exchange Safic offers long-term blue sky optionality.

Key Issues: Macro-economic uncertainty

Despite the promising businesses in Accéntuate’s stable, the Group’s prospects rely very much on the activity, timing and quantum of a recovery in the local construction and infrastructure markets. While the long-term prospects of these sectors remain positive, there remains significant short-term macro-economic uncertainty.

Forecast, Valuation and Implied Return: Appears very inexpensive

We have pegged our valuation to our segmentally-driven SOTP DCF model, implying that ACE has a fair value of 114cps. This would put the share on a comfortable 10.6x PE and also implies that the current share price of 85cps undervalues Accéntuate by c.35%.
Rolling forward our fair value, we arrive at a 12m TP of 132cps with an Exit PE of 11.0x, which is slightly elevated due to Ion Exchange Safic adding to our valuation but its operations not yet adding to the Group’s profits.
Our 12m TP implies an attractive c.56% return.
Finally, even if Ion Exchange Safic is excluded from our valuation (assumed to be of nil value), the share’s fair value still appears between 90cps to 100cps, thus lending some comfort to our view that the share is currently undervalued.

Download Accentuate Initiation of Coverage Here

What do you think of Accéntuate? Let us know…

See our methodology here and note our disclaimer here.

About Blue Gem Research (Pty) Ltd

Blue Gem Research is built upon the belief that we can make the market better.

A structural bottleneck in the South African equity market is that sell-side analysts are incentivized via allocation, trade volumes and related brokerage to cover large, liquid stocks. While this can add value to the market, the law of marginal diminishing returns implies that it adds less and less value as more and more analysts cover the same finite number of stocks (i.e. the Top 40 index on the JSE).

Even the few analysts covering stocks outside this Top 40 index are incentivized to cover the more liquid counters in this universe to effectively monetize their time (and time is the real cost of research).

The irony is that the very stocks that would benefit the most from being professionally researched are the very stocks that are also marginalized by these sell-side economics: the dynamic, growing, exciting micro- and small-cap counters that do not feature on this radar due to size, illiquidity or both.

And so Blue Gem Research was founded to address this critical need in the local market and, by doing so, help our market work better for all participants.

The logic is simple. Research on the under-covered small caps cannot be economically monetized by brokerage. But, the benefit of professional coverage is felt directly by the small cap company itself. Hence we charge the company being covered directly for its coverage and provide the research to the rest of the market for free.

We need to be clear, Blue Gem Research produces commissioned research. But, let us also be clear, all research is indirectly paid for by one or more parties. We are merely being transparent about this fact on this website and in our research disclosures.

Offering the market selective commissioned research of small caps solves numerous challenges:

Investors and the general market can benefit from freely available professional research on these under-covered stocks (you do not need to agree with every word or conclusion in a research note to take value from the work done and presented in it),
The small caps can feel the benefit of professional coverage from added exposure in both the investment community and the general public, and
The research is sufficiently monetized to justify the time, effort and expense of building and maintaining it.

Essentially, this is Blue Gem Research’s rationale: balancing the risk of commissioned research against the vast potential value-add to the broader market and individual stocks we have chosen to cover.

If you are new to reading professional research reports, some terms and abbreviations may be new to you. Please see our Frequently Asked Questions page we answer some of the most common questions thrown at us regarding Blue Gem Research.

Finally, read our Disclaimer page disclosing some of the finer legal details of our research. By browsing this website and its research (even if you received it in your inbox or via social media), you are assumed to have read, understood and agreed to this disclaimer.

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Keith McLachlan