A Portfolio of AIM Shares (4); Alternative Networks and F W Thorpe

Note: For the preliminary filters used to select AIM stocks, see http://thejoyfulinvestor.blogspot.co.uk/2013_09_08_archive.html

Alternative Networks PLC

Avaya voice over IP phone, courtesy Wikipedia

 

London-based Alternative Networks (AN) has developed a successful business as an intermediary between telephone providers and small and medium sized enterprises (SMEs). AN helps SMEs configure their fixed line phone, mobile phone and data streaming requirements. The company provides a complete service for its customers, from the provision and installation of telephone equipment through to billing, security and after-sales service. As an added inducement, AN, which receives discounts as a wholesale telephone user, offers SMEs savings on their telephone bills. 

AN relies on its relations and fixed-term contracts with the large mobile phone operators (Vodafone and O2) and fixed phone suppliers (BT, Cable & Wireless and Verizon) to obtain wholesale discounts. 

AN derives 37% of its revenue from mobile phones, 32% from fixed line and 31% from what it calls 'Advanced Solutions' - computer-based voice, data and billing services. Advanced Solutions are the intellectual property of AN. 

AN was listed on the AIM market in 2005. Its shares are currently free of inheritance tax; the 'free float' is 52% of its outstanding shares and the bid to offer spread is a reasonable 1%. The company is capitalised at 171 million pounds. 

James Murray, Executive Chairman and founder of AN, holds 30% of AN's shares. He is 43 years old. 

AN (in blue) has been an excellent investment for its shareholders, outperforming by a wide margin the FTSE All Share Index (in green) since floatation:

 

Graph courtesy Yahoo, click to enlarge

 

This reflects AN's success in its niche market: 

1. Earnings per share have increased at a compound rate of 15% per annum, well ahead of the 10% p.a. compound growth rate in revenue since 2006. Dividend payments have increased correspondingly.

2. The return on retained earnings these last six years, at 22%, is close to the historic ROE of 23%. And net margins are a healthy 11%. 

3. Equity per share has compounded at 11% per annum since 2006. 

4. The company has always held a net cash balance since floatation. This stood at 15 million pounds at March 2013.  

5. AN's net operating cash flow in the past five years covered the dividend 2.7 times, leaving 31 million pounds for acquisitions, a special dividend and share buybacks. 

6. AN presents a clean balance sheet. It offers its employees a defined contribution pension scheme and does not carry the risks associated with a defined benefit pension scheme.

 

In the 2013 Interim Report, revenues declined by 4% and EPS improved by 4% compared to the first half of 2012. Murray assures us that the decline in revenues belies an improving trend in revenues and he has promised a 10% increase in the dividend for both 2013 and 2014 fiscal years. 

Growth, Murray writes, " will be achieved in three key ways:-

We will step up our efforts to target larger customers . . . with an emphasis on selling managed data services. We will also focus on cross selling IP and data services into our legacy Enterprise customer base taking predominantly mobile and fixed voice.

We will use our Synapse portal product, a vital service differentiator, to make further inroads into the Business markets segment of our customer base (80 - 500 employees).

We will make more use of our wholesale and partner channels, leveraging our billing products and channel clients." (Chairman's statement in the Interim report)

And  AN will continue to acquire smaller competitors.

At the current offer price of 352p, AN's shares are on an historic PER of 18 and yield 3.4%. My valuation model gives a valuation of 300p for the shares.* The shares traded at a 12-month high of 355p (3 October 2013) and a low of 198p (October 2012).

*Assumptions: EPS growth of 10% p.a., equity per share growth of 11% p.a., ROE of 22%, average PER of 15, dividend payout 60%; discount rate of 11.8% (3.8% SLXX + 3% operating risk + 5% margin of safety), all for the years 2013-17.

 

The main risks for the company are: 

1. That the regulators depress retail telephone prices without the providers lowering wholesale prices. This would squeeze AN's margins. This has already had an impact in the first half of 2013. 

2.  Telephony's rapidly changing technology means that unpredictable changes in demand could affect AN's business model. 

3.  AN depends on its good relations with mobile and fixed line operators, which are very large businesses, quite capable of entering AN's market if they so wish.  

4. Revenues have stalled in the past year and a half. Despite Murray's protestations, does this suggest that the company has exhausted its potential market? While owner-managers are wonderfully committed to their business, they are often the last person to acknowledge that the good times have come to an end.

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F W Thorpe PLC

 

LED flute light, courtesy F W Thorpe website

From telephones to lighting.

Founded in 1936, F W Thorpe, the Midlands-based lighting specialist, floated on AIM in 2006. The current Chairman, A B Thorpe, is a grandson of the founder, and the Thorpe family controls 51% of outstanding shares. 

The shares in Thorpe are currently free of inheritance tax, the 'free float' is 44% of outstanding shares and the shares trade on a bid to offer spread of 7%. Thorpe has a stock market valuation of 135 million pounds. 

In the 2012 Annual Report, Thorpe describes its business most succinctly:

 

"We specialise in designing and manufacturing professional lighting equipment. We currently employ approximately 470 people and although each company works autonomously, our skills and markets are complementary. Our focus is for long-term growth and stability achieved by developing market leading products backed by excellent customer service."

 

By far the largest component of the lighting business is Thorlux, specialising in commercial and industrial lighting systems. Thorlux contributed 82% of Thorpe's sales in 2013 and virtually all its profit.  

Thorpe shares (in red) have more than doubled in the last 5 years, a superior performance to the FTSE All Share Index (in pale orange):

 

Courtesy the Investors Chronicle, click to enlarge

 

The company has consistently maintained healthy margins and it has increased revenues over the past 10 years, even during the financial crisis. Its net cash position and freedom from debt has been another feature of the business. Consider: 

1. Earnings per share have grown at a compound 13% per annum since 2004 on revenues that have increased by 6% p.a. The net margin in 2013 was 21%.  

2. Equity per share has grown by a compound 14% per annum since 2004. This was achieved by retaining a very high proportion of its profits until this year. 

3. The historic return on equity of 13% is similar to the return on retained earnings of 14%. Thorpe is a business that requires regular capital spending on plant and facilities. It has also launched new businesses and acquired others.  

4.  Thorpe has no debt, but has 34 million pounds cash on its balance sheet, or one-quarter of its market capitalisation. 20 millions of the 34 millions are customer deposits. 

5. In the past five years net operating cash flow after capital expenditure amounted to 26 million pounds, which covered the dividend 2.2 times. 

6. The defined benefit pension scheme was closed to new entrants in 1995. Consequently, the actuarial estimates of pension liabilities are relatively stable and fully provided for. 

Thorpe's main business is driven by the refurbishing and building of premises for commercial and industrial use. The development of Light Emitting Diode (LED) lights, which promise lower consumption, longer life and more flexibility than fluorescent and incandescent lighting, has also significantly improved demand. 25% of Thorpe's sales are now LED and the company has invested in new plant to increase its manufacturing capacity.  

Sales and profits were slightly lower in 2013 than 2012. The Chairman explains that this is the result of: 

1. Not being able to produce as many LED lights as customers required. Hence the new plant. 

2. A lower order book than 2012 at the beginning of the year.  

3. Continued start-up costs at its new venture, TRT Lighting, which specialises in lighting for tunnels, streets and open spaces. This unit lost 0.5 million pounds and will continue to lose money "for some while" (the Chairman). 

Management seems to be distracted by its small units. TRT is loss making and its main customer the public sector, to the evident frustration of the Chairman, is accustomed to buying imported lighting. Compact Lighting (retail and display) made a loss and it has a new sales director. Sugg Lighting, which specialises in refurbishing heritage lighting is also loss making and it has a new management team. Here there is cheaper competition from 'family businesses'. Solite Europe, the largest supplier of lighting to hospitals and laboratories in the UK, has a new sales director. And in 2012, Thorpe purchased Portland Lighting, the largest UK manufacturer of sign lighting. Both Portland Lighting and another subsidiary, Philip Payne, which specialises in exit signs, are said to be doing well. All together, these six units billed just 11 million pounds in sales and made 0.3 million pounds profit in 2013.

86% of Thorpe's sales go to the UK, but Thorlux also has offices in Ireland, Germany and Australia. The export market is not growing as well as the company hoped. The Chairman wags the proverbial finger at the Munich office and reckons both it and Australia must do better. 

With Thorpe's shares trading on a PER of 14 and yielding 2%, are they worth buying at 115p? My valuation model values Thorpe shares at about 100p.* But this assumes that, with the new LED production capacity and actions taken in three of the units, Thorpe will recover its stride and past earnings growth, though at a more sedate 8% p.a.

*EPS growth of 8%, equity per share growth 12%, ROE 13%, average PER of 12, dividend payout 36% of earnings, discount rate of 9.8% for 2014-18.

Thorpe is a conservatively run business. Nevertheless, there are risks: 

1. The overall lighting market for UK producers is shrinking, according to The Electric Lighting Equipment Manufacturing market research 2013. And "It is clear from this study [Plimsoll report 2013] the lighting market is going through a period of great change and the market is highly competitive."  This will not be news to Thorpe.  

2. LED lighting is becoming the standard for many of Thorpe's customers. And the Chairman notes that there are many new companies - start-ups - in the LED market. Also, many LED lights are imported. This could lead to more competitive pricing and loss of business. 

3. New lighting technology could move demand from LEDs. But, given the conservative nature of the lighting business, Thorpe should have plenty of time to respond to such a change. 

4. Investors are confronted with a bid to offer spread of 7% for Thorpe shares. This is an all too common feature of AIM and discourages investors.

 

 

 

 

 

 

 

 

Initial Public Offerings

And Royal Mail PLC

Son of Man by Magritte, courtesy Wikipedia 

 

"Investors even remotely tempted to buy new issues must ask themselves how they could possibly fare well when a savvy issuer and greedy underwriter are on the opposite side of every underwriting. Indeed how attractive could any security underwriting be when the issuer and underwriter have superior information as well as control over the timing, pricing and stock or bond allocation?" (Margin of Safety, Seth Klarman, 1991). 

 

Klarman was writing about Wall Street, but things are no different in the City. The Alternative Investment Market (AIM), where every company has staged an initial public offering (IPO), is a good proxy for the IPO secondary market. Since 2000, AIM (in blue) has lost 60% of its value compared to the FTSE All Share (in green), where most companies have long been listed on the exchange:*

 

Graph courtesy Yahoo, click to enlarge

*AIM was founded in 1995, but the current index only goes back to 2000.

 

However, in 2012 the average IPO on the main market gained 10.2% in value in a year when the FTSE All Share gained 12%. Some IPOs saw their share price increase in excess of 50% while others fell sharply.

 

It pays the investor to take special caution over IPOs and ask the following:

 

1. Is the risk analysis that accompanies the prospectus consistent with the optimistic outlook propagated by the underwriters?

 

2. Is the company raising new funds to invest in the business or is it merely a means for existing shareholders to realise their gains? This is particularly pertinent when private equity is behind the IPO; they load up the issue with debt and are experts at getting a full price for their investments.

 

3.  Is the company coming to market at the peak of its cycle? 

 

Klarman notes that investment trust IPOs are especially poor value. Some, he claims, are driven solely by "the lust for underwriting fees". Investment trusts must pay several percentage points to get a listing and then they usually fall to a discount on net asset value. The IPO investor is out of pocket on both counts. Also, investment trust IPOs are most frequent at the top of the market and absent at the bottom of the market. Much better to buy in the secondary market.

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Royal Mail PLC

 

Royal Mail messenger, courtesy Wikipedia 

 

Royal Mail has shed its post offices, the 2.7 billion pounds deficit on its defined benefit pension fund and it is reaping the benefits of large price increases forced through in 2012. The spruced up Royal Mail is coming to market. The last day for applying for shares in the IPO is 7 October. 6 days later, the Treasury will decide the share price, which will be between 260p and 330p. On an implied forecast yield of 6.7% and a PE ratio of 11 on its mid-price of 295p, Royal Mail has already received offers from institutional investors in excess of their allotment. 10.2% of the new shares will go to the benefit of Royal Mail's employees, who will not be permitted to sell them before April 2017. 

 

 

But has the Treasury merely dressed up a venerable old nag, pumped him up with hormones and offered him to the public for a consideration of 3 billion pounds, take or leave a few hundred million? If this seems a harsh question, consider (data is from Royal Mail's prospectus): 

 

1. Operating risk.

        I.            The Market

 

Royal Mail has 99% of the UK letter market, which is in long-term decline. As it provides the universal postal service, Royal Mail is subject to quality and economic controls by Ofcom. The company has 33% of the UK parcels market, which is growing slowly and is highly competitive. It also has a profitable European parcels business.   

 

      II.            Revenue.

 

Billion pounds	FY 2013	FY2012	FY2011
Letters UK	4.7	4.6	4.5
Parcels UK	2.9	2.6	2.3
Parcels Europe	1.5	1.6	1.5
Total Revenue	9.1	8.8	8.3

 

 Revenue has been inching up thanks to price increases: 

 

Percentage changes	FY2013 on FY 2012	FY2012 on FY 2011
Weighted price change	+7.4%	+5.2%
Weighted volume change	-4.1%	+0.8%
Revenue change	+3.4%	+6.0%

 

Going forward, PwC forecasts (PwC Strategy & Economics – The Outlook for UK Mail Volumes to 2023) that UK letter volumes will decline by 5% p.a. through 2018 and that UK parcel volumes will increase by 3.3% p.a. Given the greater weighting of UK letters compared to UK parcels, Royal Mail's overall UK volumes are likely to decline.  

 

Royal Mail hopes to grow its European parcels company, GLS. GLS obtains 71% of its revenues from France, Germany and Italy and Royal Mail has targeted Spain and 'emerging Europe' for expansion. This makes sense since GLS's margins are better than the UK business. But volumes there have increased by just 2% p.a. in the past 2 years and this represents just 16% of Royal Mail's revenue. 

 

    III.            Pricing

 

1st and 2nd class letter prices have increased by a compound 11% p.a. since 2006. The last increase of 30% for 1st class and 39% for 2nd class letters was effective April 2012. This huge increase, taking effect one fiscal year prior to the IPO, strongly suggests that Royal Mail would not have been saleable without it.

 

Ofcom has stated that it will allow Royal Mail freedom to increase the 1st class letter rate, but that it will freeze the 2nd class letter rate for a number of years in real terms (i.e. permitting increases in line with the CPI). Royal Mail says that Ofcom will limit its net margins on letters to 5 to 10% of revenue. 

 

    IV.            Operating costs

 

Royal Mail's 167,000 employees account for 57% of all costs. Royal Mail has undertaken an efficiency programme called 'transformation' to mechanise parts of the service. Efficiency gains are declining and most of the programme will end in 2014. 

 

	FY 2013	FY 2012	FY 2010
Efficiency gains %	1.7%	3.2%	4.4%

 

Royal Mail's objective is to make efficiency gains of 2 to 3% going forward, but there is no explanation of how this is to be obtained beyond FY 2014. 79% of all letters sequenced to final delivery points are now sorted mechanically versus only 8% in 2010. There does not seem to be much opportunity for further such efficiencies. 

 

Another obstacle to cost reduction is the requirements of the universal postal service. While letter volumes are shrinking, the number of delivery points is increasing. This means higher fixed costs for Royal Mail on lower revenues. 

 

Royal Mail has limited the increase in operating costs to 2% p.a. for the last 2 years. But can it continue to keep cost increases below inflation beyond 2014? 

 

      V.            Profit 

 

Pounds millions	FY 2013	FY 2012	FY 2011
Profit /loss after tax*	282	(89)	(464)
% of revenue	3.1%	(0.9)%	(5.6)%

*Excludes charges/gains from deferred tax 

 

Royal Mail, until FY 2013, was a loss-making concern. No profit or revenue forecast is included in the prospectus. The first quarter of FY 2014 has begun with a net profit (excluding movement on deferred tax) of 126 million pounds, compared to 55 million pounds for the first quarter of last year. But the rest of the year could be badly affected by industrial action (see below). 

 

    VI.            Return on Equity

 

The return on equity of the Royal Mail for the past 3 years has been 20% for FY 2013 and negative for FY 2011 and FY 2010.

 

 

2. Risk of Industrial Action 

 

Royal Mail employees below managerial level are represented by the Communications Workers Union (CWU). The union is balloting its members for strike action between 27 September and 16 October. In the prospectus, Royal Mail makes it clear that it expects industrial action, including a strike. The CWU is opposed to the privatization of Royal Mail and wants, according to its Deputy General Secretary Postal:

·         An increase in pay that betters the increase in the cost of living

·         A better defined contribution pension scheme

·         Strengthening Royal Mail's commitment to the defined benefit pension scheme (see below).

3. Political Risk

The Labour party opposes the privatization of Royal Mail. It has announced that it would, if elected, impose tight conditions on both the pricing and service quality of the company. Since sooner or later Labour will win an election, investors should be prepared for:

·         A possible renationalization on unfavourable terms

·         Price and efficiency controls that could require further financing by Royal Mail's shareholders.

4. Risk that the dividend will be cut.

 In the 3 years included in the prospectus, Royal Mail had an accumulated shortfall of 154 million pounds in free cash flow.*

Pounds millions	FY 2013	FY 2012	FY 2011
Free cash flow*	332	(31)	(455)

*Net of capital expenditure including software.

 

Net debt is a manageable 35% of equity at June 2013. While Royal Mail will almost certainly pay the 13.3p dividend per share, costing 133 million pounds, forecast in the prospectus, future dividends depend on operating performance.  

5. Defined benefit pension scheme (DBPS) risk.

The Treasury has removed the 2.7 billion pound deficit on Royal Mail's balance sheet for the DBPS. From March 2012 onward, Royal Mail is liable for the defined benefit pension of its members. It was only closed to new members in 2008 and  the current membership is 112,000.

 

In a rambling passage in the 477-page prospectus, Royal Mail avoids any sensitivity analysis on this liability. However:

·         Royal Mail currently pays 400 million pounds a year into the DBPS.

·         It was forecast that Royal Mail would have to pay a further 300 million pounds annually into the DBPS. The company imposed a 'reform' without the agreement of the union. This would reduce this contribution to 50 million pounds annually from 2016 if the Trustees so require.

·         There is also a small deficit on the senior executive pension scheme.

A further 300 million pound a year contribution would most likely wipe out Royal Mail's profits.

With the limited information at hand and the many uncertainties surrounding the business of Royal Mail, it is not possible to run a valuation for the company. IPOs that use the new funds to expand the business of the issuing company are much more desirable than IPOs that solely reward existing shareholders. Royal Mail falls into the latter category.

[Note: I will be returning to the portfolio of AIM shares next week.]