Tindall abandons plan to privatise Warehouse – NZ Herald 30 Oct 2006

This isn’t a big surprise – This was our analysis earlier.  This is a great example of a valuation process in a mergers and acquisition setting.  This is our analysis showing some of the principles we have previously discussed.

The timeline:

With The Warehouse under the current business plan the share price was at $5.11 with average analyst estimates at $4.70 in mid-September 2006.  The Valuecruncher valuation for The Warehouse produced a mid-point valuation of $4.50 – Valuecruncher The Warehouse Valuation.

On the 14^th September Stephen Tindall announces a plan to acquire 100% of the company and take it private (with Australian private equity fund PEP) to implement a new business plan – offering $5.75 a share.

The share price immediately goes above $6 and then on the 27^th September Woolworths acquires 10.1% at $6.50.

Stephen Tindall goes on holiday on the 29^th September – saying he will consider next move.  On the 30^th October Tindall announces he is abandoning plan to acquire 100% and implement new business plan.

This is what we saw happen:

Stephen Tindall has a plan that he believes will make The Warehouse more valuable than it is currently.  He believes that is easier to execute as a private company.  He does some analysis on the valuation of the new business plan against the current plan – that is being valued by the market.  Tindall and PEP value the new business plan at a set level – for illustration purposes only we will use $8 a share.  The Tindall/PEP strategy will be to implement the new business plan as a private company then to take the company public again down the track – to realize their gains.

Tindall/PEP looks at the current share price of $5.11 (pre-announcement share price) and decides to offer $5.75 for the shares.  This is above the current share price – but below the valuation they view for the new business plan of $8 (that figure is just for illustration – and is not our view of the worth of the new business plan.  We have no information to assess the Tindall/PEP potential plan).  This is the Tindall/PEP group looking to pay away some of the value of their business plan over the current share price to achieve the transaction.

Tindall/PEP are then surprised as the market places a $6+ share price to complete the acquisition – expecting Tindall/PEP will have to go up from the $5.75 offer.  I believe that this was a shock to Tindall/PEP as they viewed $5.75 as a very reasonable offer.

Then there is the further complication of competitor Woolworths acquiring a 10.1% stake at $6.50 – that allows Woolworths to prevent the privatization plan.  For Woolworths it is a purely defensive play – it gets them influence in the process so they can be involved in the ultimate outcome.  As we noted in our previous post – Stephen Tindall has a plan for the New Zealand retail sector (the new Warehouse business plan) and that would be a concern to all major competitors.  Woolworth’s response was to get a seat at the table – no matter the cost.

With the share price around $6.50 the Tindall/PEP plan is in difficulty.  To complete the transaction Tindall/PEP will need to pay at least $6.50 with their new business plan making the company worth $8 (our illustrative figure).  Assuming it will take three years to implement the new business plan and to list the company and realize the gain – this would equate to a return of 23% but on a compound annual growth rate basis only 7%.  Almost better to keep the money in the bank – and certainly not the returns that the likes of PEP are looking for.  At $5.75 the return is 39% on a compound annual growth rate basis it would be 12% – assuming the $8 valuation is achieved after 3 years.  The Tindall/PEP group will have to pay too much to acquire the company - seriously diluting the returns that they would get for implementing the new business plan (and executing a new business plan would be risky to begin with).

At this stage there is only one option for Tindall/PEP – to withdraw.  And that is what has happened.  If the share price falls back to a level that makes the plan attractive – we may see it resurrected.

This Blog focuses on valuation.  From an investment banking perspective it appears that Tindall/PEP have been pretty naive if the plan was to implement the new business plan – and I believe it was.  The Tindall/PEP tactics were not strong – they seriously underestimated market and competitor responses.

On the positive side for Stephen Tindall – he controls approximately 51% of the shares (157 million shares in total – some in a charitable trust).  The Warehouse share price has risen $1.29 since the 14 September announcement (was $5.11 pre-announcement and is now $6.40).  That is a wealth increase, based on those 157 million shares, of just over NZ$200 million for the Stephen Tindall interests.  What have you achieved wealth-wise in the last six weeks?

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However – we would really like anyone that wants to comment to do so.  If you would like to start commenting on posts on this Blog – drop us a line at info@valuecruncher.com and we will set you up with the ability to do so.

The Valuecruncher Team

Synergy announced their mid-year (six-months to 30 September) financial result last week (Synergy six month result 30 Sept 2006).

Synergy revenues were up 4% on the prior period a year ago at NZ$18.03 million and the operating surplus before tax (EBIT) was NZ$1.219 million – an approximate 6.8% EBIT margin.

Our valuation (Synergy Valuation) assumed 3% annual revenue growth and a 5.0% EBIT margin.

We believe this is further evidence that our valuation is about right.  We will see where Synergy is at year-end before we would look to make any changes our valuation.  5% EBIT margins should be the bare minimum that Synergy is looking to achieve.

Synergy placed a lower valuation on the shares in a release to shareholders in August (Synergy valuation notice).  We are comfortable with our analysis and still believe Synergy’s advice to shareholders at the low end of any valuation range.

Here at Valuecruncher we are fans of Mark Weldon – the CEO of NZX.  We think that he has done a great job at NZX.  New Zealand’s capital markets are certainly in far better shape than they were before he arrived.  We view Mark Weldon as strategically sound and a good leader – he sets the direction and then lets his talented team (that he assembled) deliver the outcomes.

Last week NZX delivered their third quarter results.  We decided to have a look at the results and see what we think about the NXZ share price.

NZX Third-Quarter Announcement

The NZX result was very good.  Operating revenues were up 16% on the 2005 year-to-date period.  EBIT was up an impressive 34% on the year-to-date 2005 period.  These are some good results showing that NZX are growing the core business and generating better profitability.  The quarterly EBIT number was down 5% due to some big floats in the corresponding quarter in 2005 – not a big deal.

NZX also returned NZ$16.2 million to share holders in the quarter – because they did not need the cash.  This is a good thing – a company recognizes it doesn’t need all the cash it has and returns it to shareholders.  Too often we see companies unwilling to return excess cash to shareholders – and pursue non-core opportunities.  In our opinion – we have invested in your company for the business plan outlined and if you don’t need all the available cash then we are the ones to determine where it should be invested.  NZX should be applauded for this – the correct act.

So how did the media respond to the announcement?  The NZ Herald focused on the 11% decrease in net profit (http://www.nzherald.co.nz/search/story.cfm?storyid=000276D6-494A-1537-962F83027AF1010F).  They did note that interest income fell by one third – which is what happens when you make a positive move like returning $16.2 million in cash to shareholders.  Radio NZ and other media outlets also focused headlines on the 11% decrease in net profits.

This type of coverage must have driven NZX mad – you produce a good operational result and people focus on the “wrong” number.  Good operational numbers – see results from operational revenues and EBIT.  There is a drop in net profit – because we had less interest income from returning excess cash to shareholders.  If people have invested in NZX for interest income from cash held on the balance sheet – they have missed the point.  Headlines are about drop in net profit.  Just crazy – poor quality analysis all around.

To be fair to all media outlets – NBR were on the mark (http://www.nbr.co.nz/home/column_article.asp?id=16493&cid=4&cname=Business+Today).

So what do we think about the value of NZX shares?

A Valuecruncher valuation for NZX is included at the bottom of this post.

The assumptions we have made in the valuation are as follows:

We have assumed that revenues grow from NZ$19.5 million in 2005 by 20% in the 2006 year then 15% in 2007 and 10% in 2008.  This results in revenues of NZ$23.4 million in 2006, NZ$26.9 million in 2007 and NZ$29.6 million in 2008.  Three quarters of the way through the 2006 financial year NZX have revenues of NZ$16.4 million – 70% of the way to our NZ$23.4 million figure.

For EBIT we have assumed a 30% EBIT margin in 2006 and then 35% in 2007 and 2008.  This results in an EBIT of NZ$7.0 million in 2006, NZ$9.4 million in 2007 and NZ$10.4 million in 2008.  Three quarters of the way through the 2006 financial year NZX have EBIT of NZ$5.2 million – 74% of the way to our NZ$7.0 million figure.

We have assumed NZ$1.9 million of capital expenditure in 2006 – then dropping to a stable NZ$0.5 million per annum from 2007.

We have used the latest balance sheet numbers for the net tangible assets – removing the cash returned to shareholders and adjusting shares outstanding for stock splits.  We have also assumed that acquisitions recently made are NPV neutral for valuation purposes – i.e. acquisitions (for example FundSource) have been done at fair values.

Our mid-point share price is $3.24 – the current share price is $6.15.

Our valuation is 53% of the current share price.

Our valuation on a historic EV/EBIT (enterprise value/EBIT) basis is 12.0x compared to 24.1x implied by the current share price.  On a forecast EV/EBIT basis (using the Valuecruncher EBIT forecast of NZ$7.0 million for 2006) our valuation is 9.6x compared to a 19.3x implied by the current share price.  Those are some big multiples for NZX to be currently trading on.

Let us put those into some context.  TradeMe is located in the same building as NZX.  TradeMe was sold to Fairfax at a 26.9x historic EV/EBIT ratio and a 15.6x forecast EV/EBIT ratio.  TradeMe had an enterprise value of NZ$700 million based on the acquisition by Fairfax and NZX has an implied enterprise value of $135.4 million – which is interesting in that what is the most valuable “market” in New Zealand.  Also that each dollar of forecast 2006 EBIT is being valued higher for NZX (by the market) than by Fairfax in the acquisition of TradeMe.  TradeMe with 40%+ EBIT margins and growing at 9-10% a month.

TradeMe had EBIT in 2005 of NZ$26 million and forecast 2006 EBIT of NZ$45 million.  NZX had EBIT in 2005 of NZ$5.6 million and we are forecasting NZ$7.0 million for 2006.
NZX looks to be highly over valued at the current share price based on this analysis.  The fundamental discounted cash flow valuation is well below the current share price and the EV/EBIT ratios look out of line as well.

What is going on then?

Two possible answers:

1. We are significantly under-estimating the growth and earnings potential of the NZX business – the core New Zealand business (including early initiatives such as SmartShares), the acquisitions (i.e. FundSource) and the investment in Australia.  This is possible – and we have been conservative with our assumptions.  But to get to the current valuation levels suggested by the NZX share price we would need to be well below on our forecast numbers.

2. There is currently a wave of consolidation occurring in the major financial exchanges of the world.  The Australian companies ASX and SFE merged in July 2006 to create the world’s ninth largest financial exchange – we have used a rough merged model in our Valuecruncher analysis to show what the comparator looks like.  On October 17^th the Chicago Mercantile Exchange (CME) and Chicago Board of Trade (CBOT) announced a US$8 billion merger.  The London Stock Exchange (LSE) has been the subject of takeover proposals from Macquarie Bank and NASDAQ – in the last 12 months.  We have included LSE in our comparator set with our Valuecruncher valuation.

All this activity appears the result of the globalization of financial markets – heading toward ultimately global markets for all financial products with a lot of liquidity and low transaction costs.  Or it could be a defensive move by exchanges wanting to maintain price levels – and therefore profitability.  That is a big argument – with the jury still out.

This takeover activity has driven the valuations of these financial exchanges to historically high levels – based on the assumptions that there will be bidding wars by the major players to acquire these assets.  The markets appear to be factoring in these bidding wars to valuations of financial exchanges – including NZX.

NZX may be an ultimate acquisition target by a group involved in the consolidation playing out.  But the very small size of the New Zealand market compared to other exchanges means that NZX will not be a material asset for any of these groups – ASX has a current market capitalization of A$5.6 billion and NZX has a market capitalization of NZ$144.6 million.

The only logical buyers are Australian – ASX or Macquarie.  Or a speculative play by a hedge fund acquiring exchange assets in anticipation of being part of the consolidation.  But – at the current valuation levels NZX will look expensive to these players.  The market appears to be valuing participating in the global consolidation of financial exchanges in NZX’s share price.  Because of the small size of the NZX – compared to global players – we would think NZX will be part of the final mop up not an initial acquisition.

We think that No. 2 is the most likely scenario – and if global players decide to bid for NZX then the price might be reasonable.  But based on our analysis of the valuation of NZX – there doesn’t appear to be the underlying profitability to justify the current share price.

We like Mark Weldon – but don’t think NZX is worth what the market is saying.

NZX Valuation

As an illustration of valuation methodology we have decided to have a look at two companies that have recently listed on the Unlisted market (www.unlisted.co.nz).  Unlisted provides a platform for trading shares of companies – without the same level of compliance required, and cost, as on NZX (www.nzx.com).

In August we saw the debut of two IT services companies – Synergy (www.synergy.co.nz) and Infinity (www.infinity.co.nz) – on Unlisted.  Neither of the companies have yet had a share trade on Unlisted at 10 October 2006 – lack of liquidity in the market is a feature of Unlisted.  Synergy (Unlisted:FSG) has a sell offer at $1.75 and no buy orders – i.e. someone is willing to sell at $1.75 a share but there are no buyers.  Infinity (Unlisted:INFINITY) has buy orders at $0.40 and sell orders at $0.50.  Neither company has a lot of depth – i.e. not a lot of people looking to buy or sell shares.  If you were a shareholder in either of these companies – what might be an indication of value for the shares?

So what does Valuecruncher think the valuations for these two companies should be?  We took only information that has been released by the companies on their websites and some assumptions that we lay-out in the valuation reports in determining our values.  Copies of the valuation reports are attached to this post.

Remember that to get to the share price we start by calculating the present value of the future cash flows generated by the business – this is called the Enterprise Value.  From the Enterprise Value we remove Net Debt – long-term borrowings less cash – to obtain the value of the equity in the business.  We divide the Equity Value by the number of shares outstanding to get to the value per share or share price.

The information below summarises our analysis of the valuations of Synergy and Infinity.

Synergy - $11.1 million Enterprise Value and ($1.2) million Net Debt equals an Equity Value of $12.3 million and with 7.0 million shares outstanding gives a share price of $1.75.  

Infinity - $22.1 million Enterprise Value and ($4.6) million Net Debt equals an Equity Value of $26.7 million and with 58.7 million shares outstanding gives a share price of $0.45. 

Because both Synergy and Infinity have cash on their balance sheets and no debt – the Net Debt figures are negative and being deducted from the Enterprise Value to determine the Equity Value mean that the Equity Value is above the Enterprise Value. Our valuation reports use as comparators the comparable IT services transactions of Telecom acquiring Gen-I and Telstra acquiring Sytec.  Both the Valuecruncher valuations are just below the two comparators – but are reasonable compared with these transactions.Financial advisers that work in the IT services space generally tell clients that industry transactions occur in the 2-4x EBIT valuation range.  Using that as a guide (and 4x EBIT as the valuation) – would imply Synergy would have a share price of $0.94 and Infinity $0.33.  Synergy has had an independent valuation report commissioned that gave a share price range between $0.50 and $1.56 – and this has been communicated as guidance to shareholders (http://www.synergy.co.nz/AboutUs/News/NewsItems/2006-08-01_Notice_to_Shareholders_Synergy_International.htm).  This is below our valuation mid-point of $1.75 and the bottom end is below our NTA calculation of $0.62 per share.

Our Take

We are comfortable with our valuations of both Synergy and Infinity.  No trades have occurred for either company on Unlisted – Infinity has a buy offer at $0.40 and sell offer at $0.50 (Valuecruncher valuation $0.45) and Synergy has a sell offer at $1.75 (Valuecruncher valuation $1.75). The Synergy valuation advice to shareholders of between $0.50 and $1.56 is below what we think the shares are worth.  The 2-4x EBIT valuation range advice (for the IT services industry) also seems low to us when applying discounted cash flow techniques.  The transactions involving Telecom and Telstra in the New Zealand IT services space are slightly above the valuation levels we are getting to – there may have been some optimistic views from the acquiring parties about potential synergies available.

It is also worth noting that the EBIT margins for these businesses are in the 4-5% range – which is pretty unattractive really (Telecom NZ operates a 25-30% EBIT margin and The Warehouse currently operates at 9%).  Other IT services businesses operate with higher EBIT margins – Datacom operates in the 8-9% range (http://www.datacom.co.nz/default.asp?Content_ID=430&Category=News).  While Datacom may have more recurring revenues than Synergy or Infinity – we are surprised about the different levels of performance.  Synergy had an EBIT margin of 4.1% and Infinity 5.5% in their last financial periods.  Infinity’s Directors Report for the first half of 2006 states that while earnings are good they will be below the 5.5% EBIT level of 2005 for the 2006 year.  Valuecruncher has used 5% for the EBIT margins in our valuations.  However we are surprised at the low level of earnings in the IT services space.  We are sure that management of both Synergy and Infinity are looking to improve financial performance.

Our valuation suggests that the buy and sell orders for Infinity are in the right general area.  Our valuation of Synergy is above the guidance that the Synergy Board has given to shareholders but in line with the current sell order on Unlisted.  Our valuations are sensitive to the profitability of the companies – changes in performance (positive or negative) will impact valuation levels.

We will come back and look at these companies again later – and see if financial performance does improve.

Synergy Valuation

Infinity Valuation

Premium for control – doesn’t exist

The term “premium for control” is one that is often heard around mergers and acquisitions.  It is used to describe the reason why an acquiring company has paid more than the most recent share price to acquire the target company.  The interpretation is that the acquirer has had to pay a premium for a “controlling stake (i.e. greater than 51%)” in the business.  Commentators and company executives make comments about at 10-25% premium for control.  I have seen valuation professionals complete a reasonable valuation and then add a notional premium for control (10-25%) to come to a final value.

This is one of the most misunderstood areas of valuation.  The sweeping “premium for control” catch-all statement is misleading and often wrong.  Here is my explanation for how to think about valuation in a mergers and acquisitions setting.

The starting point is the standalone value of the business.  The discounted cash flow valuation described in my earlier post – What is a share price?  This values the business based on the current management’s business plan – as a standalone entity.  Why the focus on a standalone valuation?  A lot of technology companies would sell more if they partnered or merged with Microsoft – unrealistic to value them on that basis.

Financial markets are a fantastic invention – and we discuss aspects in future posts.  One aspect is that they require people to back their views with money – and there isn’t currently a better indicator of future prospects than people investing money in something (represented by a share price).  There is a body of corporate finance called “efficient market hypothesis” that basically states (in different forms) that markets efficiently represent information about a stock in the price of an asset (i.e. share price).  Sometimes share prices are above or below the calculated standalone value of a business – because investors (backing their views with money) think that something is going to happen (or not).  Why this is important – you will see in the example below.

When an acquiring company looks to takeover a company – it will complete its own valuation exercise.  It will build what is called a “merger model” which shows the effect of combining the potential target business with the acquiring company.  A key part of this analysis is assessing the “synergies” between the two businesses.  Synergies are basically costs that can be removed from the combined business or ways that the combined entity can make more sales than as standalone entities.  There are a range of other reasons for acquisitions such as technology or skills transfers – buying technology or people.  These will be the business case for the takeover.

The merger model will be a combined entity forecast – and allow a valuation to be completed for the combined entity.  The only party that will know the results of this analysis will be the acquiring entity.  If the synergies are positive (a key part of this work is in being conservative with calculating synergies) then there will be a positive valuation implication for the merger – the extent of this will depend on a case-by-case basis.  Because of these synergies it will place a value on the target company higher than the standalone valuation.

Then the negotiations or bid strategy will start.  The acquirer will look to maximise returns by paying as little as possible for the target company and the representatives of the target company will attempt to obtain the best price possible for the company.  The acquiring company will often pay away some of the benefits of the merger synergies to ensure the deal gets done – the economics says that they should be prepared to pay away all but the last dollar of the synergies to make the acquisition.  This is where you see prices being paid above recent valuation levels.  It is not a “premium for control” but rather the result of specific negotiations (or a merger bid tactic) where an acquirer pays away some of the synergies (or advantages) of the merger to make the deal happen.  It very much depends on a case-by-case analysis.  Be very wary of people making blanket comments about “premiums for control”.

Example – 42 Below acquisition by Bacardi

Assumptions:

All of these assumptions are based on 42 Below as a standalone company.

42 Below had revenues (excluding interest) of $17.0 million at 31-March-06 – growth of 39% on reveues of $12.2 million at 31-March-05.  The March-05 revenues were 218% above the $5.6 million at 31-March-04.  Moving forward we have assumed growth of 30% in 2007, 20% in 2008 and 10% in 2009.  We think this is reasonable for a standalone company.

42 Below is currently not profitable at the EBIT or EBITDA levels.  Bacardi is privately held so there is no easily available comparator of what EBIT margins we would anticipate for 42 Below when they reach a stable level of positive earnings.  We examined the UK listed Diageo and US listed Fortune Brands – between 2002 and 2005 they had EBIT margins between 16% and 35%.  For 42 Below we used a 15% EBIT margin in 2007 increasing to 20% in 2008 and 25% in 2009.

We have made some conservative assumptions around CAPEX and depreciation to 2009.
All other inputs are from the 31-March-06 42 Below Annual Report.

Output:

Using these assumptions Valuecruncher produces a standalone per share valuation of $0.35 – well below the Bacardi offer.  This standalone valuation is also below the pre-offer share price of $0.58.  The $0.58 share price is what appears to be a good example of investors expecting a potential acquisition and assuming that into the price they would be prepared to pay for shares.  Alternatively investors may feel that my assumptions are too conservative – and that growth prospects for 42 Below are much stronger than what I forecast.

Bacardi will be valuing the company based on the sales of the 42 Below products in the Bacardi sales and distribution system (which is much larger and more developed than the 42 Below system) and then giving up some of this value in buying the company to ensure the success of the transaction.  Bacardi’s valuation of 42 Below products in their sales and distribution system will be a higher number than $0.77 per share – but to ensure the transaction succeeds some of the value is paid to shareholders.

Our analysis is that this is a great outcome for the company with a higher value owner than the current shareholders of the business taking over – at a price well ahead of the value of the business as a standalone entity.

View the 42 Below valuation

This analysis of The Warehouse was originally in the Valuecruncher Newsletter dated 18 September 2006.

1. The Warehouse is New Zealand’s biggest retailer with sales of $1.7 billion.
Late last year the company retrenched from a value destroying Australian expansion – sold assets in Australia.

2. Foodstuffs took a 10% stake in July 2006 sparking potential takeover discussions.
Interests around the company’s founder Stephen Tindall control approximately 51% of the company.

3. Early September 2006 – consensus research analysts’ valuation (per share) approximately $4.70.

4. 14 September 2006 – Stephen Tindall announces plan to acquire 100% of the outstanding shares at $5.75 a share (previous share price - $5.11) with private equity firm PEP.

5. 15 September 2006 – share price closes at $6.01 (above stated offer price) with analysts saying that $5.75 is “opportunistic” and not enough.

Our take 

Attached is a valuation we have completed on the company using the annual results presentation of 8 September 2006 distributed by the company.

Our valuation places a mid-point valuation of $4.50 – which is in line with the previous analyst forecasts of $4.70.  We are comfortable with that valuation based on the information available.  We have used 3% earnings growth – in line with the information in the annual results presentation of flat real retail sales growth.

To get to the offer price of $5.75 requires the compound annual growth rate for the next three years to rise from this 3% to 10% – holding all other assumptions constant.  That is big in the retail market.  The Warehouse grew revenues in the 2002-2005 period at compound annual growth rate of approximately 5%.

To get to the current share price of $6.01 requires an 11% compound annual growth rate.  This share price places The Warehouse at the average of the Australian and US comparators we have examined – 12.7x historic EBIT.  It should be noted that this multiple is above giant US retailer Wal-Mart – currently trading at 12.4x historic EBIT.

To get the type of growth the offer implies suggests some quite radical plans for The Warehouse and retailing in New Zealand.  Now I am not an expert in the retail market – but Stephen Tindall most certainly is.  He is putting his wealth on the line and bringing some aggressive Australian private equity players with him that have a lot of cash in this.  If I was another retailer and potentially competing with The Warehouse – I would be very concerned.  The growth is going to have to come from somewhere – and The Warehouse signalled flat real sales growth in the retail sector only weeks ago.

Putting away my valuation hat and putting on my deal hat – I am surprised about the way that the deal was announced and the price.  It appears that the Tindall Group decided to put forward a full price – under the assumption that people would be happy with that.  However, Stephen Tindall is one of a handful of New Zealanders in the business world that people have significant respect for (others on the list – Graham Hart and well not many more).  The market (including commentators and analysts) then just said that the offer was “opportunistic” – despite placing an approximate $4.70 valuation on the company prior to the offer.  We think that the Tindall Group has been surprised by the market reaction – i.e. price over $6 a share.  The Tindall Group were never planning on going up from $5.75 – and we agree that it looks a very fair price at $5.75.  I might not have started quite as high as $5.75.

This is going to be very interesting to see played out.

View the Warehouse valuation

We have also been asked questions about Feltex (NZX:FTX).  Here there is at least some information and we can give some thoughts.  NOTE: This post was originally in the Valuecruncher Newsletter dated 14 September 2006.

We wait with interest the outcomes of the discussions between the company, ANZ and the Turner Group around their proposal.

Attached is our valuation of the company – we make the following assumptions:

1. Current company forecasts of NZ$20-21 million EBITDA for 30 June 2006.
2. Earnings growth of 10% in 2007 and 2008.
3. 10% EBIT margins.
4. Net Tangible Assets (NTA) based on 31 December 2005 numbers adjusted for the latest ANZ borrowings amount.

Our valuation output is a negative number – ($0.15) per share.  We have a range from ($0.32) to $0.03 per share.  The NTA is $0.27 per share – assuming the assets hold their value.  The June 2006 accounts are not yet released but if there is no rescue package available we would anticipate the assets being written down.  The current share price is $0.11.  It doesn’t look good.

We do not have a lot of faith that the Turner Group will manage an effective rescue of Feltex.  Based on our numbers there does not appear to be a lot of value in the equity of the business – with the existing debt levels.  Our view (outside the process) is that we would expect that Godfrey Hirst is in a better position to achieve an effective outcome.  We say that based on the assumption that Godfrey Hirst can generate some operational synergies from the Feltex assets that the Turner Group cannot.  In either case the existing shareholders of Feltex will suffer.

View the Feltex valuation

We have been asked our view of the valuation of Plus SMS (NZX:PLS).  As there are no public financial forecasts we can’t place any sort of valuation on the company.  We need to understand the cash flows at some level to complete some robust valuation work.

We are however amazed at the current market capitalisation of NZ$55.4 million, with reasonable trading volumes on NZAX (regularly over 500,000 shares traded daily this month) – with the negative information that has been released.

We also agree with Rod Drury’s comments (http://www.drury.net.nz/2006/09/10/plussms-wheres-the-investigative-journalism/) that there are big moral questions around founders taking money off the table pre-revenues.

One of the common questions we get asked is why does the term EBIT or EBITDA get used so frequently in valuation work?

EBIT stands for Earnings Before Interest and Taxes (EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortisation).

EBIT is sales less expenses (including depreciation) adding back any interest paid and subtracting any interest received.  The only change to EBITDA is that depreciation and amortisation are added back.

Why EBIT or EBITDA?  Why not use net profit after tax or some other measure?

In valuation we are trying to determine a reasonable estimate of cash flows and a base level of profitability for a business that is easily comparable – cash flow for discounted cash flow modelling and base profitability to complete comparator analysis.  EBIT is the corporate finance best estimate for a firm’s cash flow.  EBIT also strips out the two key differing elements that make figures like net profit after tax hard to compare between different companies – capital structure and tax position.  We start with these.

Capital structure describes the mixture of debt and equity that a company uses to finance its operations.  With more debt (also called leverage) on a company’s balance sheet – the more interest it pays (typically).  The interest cost is included in figures like net profit after tax and can skew comparisons between virtually identical companies – where the only difference is in the amount of debt held by one company. Different prior earnings histories can also impact figures like net profit after tax.  Again if we have two identical companies today – one that has a history of losses and one that has always been profitable – in all other aspects the companies are identical with the same prospects moving forward.  At the net profit after tax level one company (the one with a history of losses) will have a higher figure than the other – as it will have been able to use its tax losses to off-set current profits and reduce its current tax bill.  Again this skews comparisons – so taxes are eliminated from the EBIT figure.

The difference between EBIT and EBITDA is depreciation and amortisation – why include or exclude depreciation and amortisation?  In both cases we are trying to estimate a base level of cash flow from the business.  The two key components of calculating this base level of cash flow are the profits that the business produces and the on-going investments required by the business to achieve these cash flows – the capital expenditure that the company needs to undertake to achieve the profitability.  EBIT includes depreciation and amortisation, which are not cash items, but that act as estimates (imperfect – but an estimate) of capital expenditure.  EBITDA removes depreciation and amortisation and thus just focuses on the profitability of a company without considering the investment required to achieve the profitability.

Depreciation and amortisation are accounting treatments that spread the cost of capital expenditure items over the term of the assets (either tangible or intangible) useful life.

The argument for using EBITDA over EBIT is that for some companies with limited capital expenditure (i.e. software firms) the figure is immaterial.  I don’t agree with this analysis – I have done a lot of work with companies that have this, so called, limited capital expenditure requirement and there is always some capital expenditure required.  I am against using EBITDA over EBIT in valuation exercises.  In a valuation you need to take into account the capital expenditure required to capture a base level of profitability.  EBITDA can be a useful number for other reasons – away from valuation.

In the Valuecruncher model we utilise EBIT as our base estimate of cash flow but request information about both depreciation and capital expenditure to better estimate cash flows from a business.