Thursday, July 7, 2011

Hidden Champion Corticeira Amorim part 2

This is the part two post about Corticeira Amorim (COR.Portugal), you can view part one here.

In the first post I discussed the business units and some of the strengths Corticeira Amorim embodies as a hidden champion.  In this post I want to focus on the financial aspects that support the thesis first presented in part one.

I am going to take a look at the following items, return on invested capital, dividend history, a duPont analysis, free cash flow yield and the degree of operating leverage.  I will show the numbers for each figure, and then have a small amount of analysis around it.  My goal is taking this post with the first post will present a full figured analysis of Corticeira Amorim.  Each specific item is titled so it should be easy to skip to a certain piece of information.

Return on Invested Capital

I calculated ROIC for the past five years:


The good news is ROIC has been increasing and rapidly the last two years.  In 2009 the increase in FCF was due to working down receivables and inventory, whereas I believe 2010 is a more accurate picture of what an investor can expect in the future.

The second item that stands out is that ROIC has increased due to the repayment of debt over the past two years.  

Dividend History

The company has acted somewhat prudently with regards to dividends.  From 2005-2007 they had a conservative payout ratio which spiked during the recession.  In 2008 they paid out 140% of earnings, and halted the dividend in 2009 while they paid down debt and strengthened their balance sheet.

I actually appreciate the decisions management made with regards to a dividend, and the quickness in which it was restored as well.  The dividend was steadily climbing in the earlier part of this decade and if results continue to grow I would expect the dividend to continue to increase.


DuPont Analysis and ROE

A DuPont analysis breaks down the return on equity to a more granular level.  A ROE is composed of return on sales * asset turnover * leverage.  Examining the breakdown in each can show how the company is generating it's ROE and if the company is working with an efficient capital structure.

Here is the DuPont breakdown for Amorim:


The return on sales and asset turnover are about average for a business such as Amorim, and ROE gets a bit of juice from the leverage.  I appreciate that the company is paying down debt, and I like firms with little to no debt, but I think a bit of debt for Amorim is appropriate in the capital structure.

FCF Yield

There are a few ways to look at FCF Yield, FCF/MCap, FCF/EV, FCF/Equity.  I just went ahead and calculated all three values.  In addition there is the tangible yield which is what the company is paying out to shareholders as dividends mentioned above.


I'm not going to lie, these are great numbers, numbers I would expect for a hidden champion.

Degree of Operating Leverage

I was fascinated by how much earnings swung up from 2009 to 2010 on a small increase in sales, so I went ahead and put together a historical view of the operating leverage for Amorim.  Operating leverage is a way to look at how the company is able to scale on a fixed capital base.  Put another way a company that's a service company has to add more people, or have the people work longer hours to increase revenue and profits which are usually at a sort of fixed ratio.  A company with operating leverage is able to increase output on the same machines (fixed capital base) and increase profit without as big of a marginal capital commitment.

Operating leverage cuts both ways, on the way up it's magnificent because each dollar of revenue is a multiple of profit.  On the way down it hurts because the fixed capital requirement is constant, so in a downturn the company could start to turn a loss just trying to maintain the facilities.


In Amorim's case the operating leverage tells the story.  Sales increased 10% but EBIT increased 152%.  Higher incremental ticks in revenue are more valuable to the bottom line.

Valuation Scenarios


Corticeira Amorim has a lot of things going for it, a great free cash flow yield, a good dividend, great operating leverage.  The company is also trading on a cheap basis, with a EV/EBIT of 5.5 and P/E of 5.5.  Given all of this I wanted to plug the numbers into a few simple valuations based on multiples.

I was originally going to do a dividend discount model but I struggled with the discount rate.  The problem is the risk free rate isn't exactly risk free in Portugal, and with most sales international Amorim isn't really constrained to one market where a national bond could be used.  I gave up and decided a multiple analysis, and a comparison to Oeneo would be sufficient.


Oeneo (SBT:FR) is in the same line of business, they trade with a P/E of 11.28 and a EV/EBIT of 9.9.  The multiples on Oeneo are reasonable and considering they are in the same line of business, in the same market it's reasonable to conclude that Corticeira Amorim should trade at similar multiples.

Resources (in English)
2010 Annual Report
2009 Annual Report
2008 Annual Report
2007 Annual Report
Company Website

Talk to Nate about Corticeira Amorim

Disclosure: Long Corticeira Amorim

7 comments:

  1. Hey Nate,

    I had long look at Corticeira today, thans for the extensive writeup. I believe the stock is cheap on earnings but from the looks of it, it is not an exceptional business (long term roic below 10%). You mention a high fcf of 42mln 2010, but i doubt that is sustainable considering the favourable Working capital conditions. Unless working capital is increasing hand over fist (a red flag), I doubt whether you should take into account the extra boost WC gave FCF in 2010. If you strip out WC you get a (in my opinion) more realistic picture of 30mln for 2010 (still great).

    I have another caveat and that concernt the current EBIT margins. 2010 was obviously a very strong year. Average EBIT margin is 6.8% between 04 and 10, more than 300bps below levels achieved in 2010. How do you view margins going forward?

    Overall seems like a very stable business that should generate (Based on the current price) returns on investment 15%+ over the coming years. Nonetheless its ROIC is rather low for a 'hidden champion'. I did an EPV analysis and arrived at a value of 1.60 PS.

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  2. Floris,

    Great comment, thanks! I agree that the ROIC isn't exciting, and it sort of surprised me as well. I think what Corticeira is doing is working to improve the product mix to include flooring and insulation which are much more profitable business lines.

    I agree with the WC comment, and I'm realizing I didn't post it on the blog, but I worked out the same numbers you did, and that jives with the long run FCF as well.

    As for margins, I am led to believe they'll continue at the level they're at. The reason for this is in the annual report the management breaks down the reasons for margin improvement, and most of them are productivity improvements which they state are sustainable. The question in my mind regarding margins is will raw material costs crimp margins at all? The annual report states they have found ways to cut costs to recover some of the increases but this can't go on forever.

    Even if 2004-2008 conditions are the norm the stock was trading in the 1.20-2 range which would be a nice jump from here.

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  3. Hi Nate,

    interesting idea. The two things that jumped out at me were

    1) margins - i have the same concern as floris. Margin improvements are always said to come from 'efficiency gains' and margin deterioration from unavoidable cost pressures. But I will take your advice and read management comments as to why margins improved

    2) the dividend yield - does portugal have a with holding tax on dividends / tax agreement with other nations? portugal is in serious distress. You can bet your house that if there is a way of taxing corporate dividends, they will find it and increase the rate substantially. I think similar things have been done in greece. Has there been chatter around this?

    thanks

    alex

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  4. I think the Portuguese withholding tax on dividends is 15% with many double taxation treaties

    Stuart

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  5. I claim ignorance on the dividend tax mostly because as an American I get a full tax credit for any foreign tax paid, although I do get taxed 15% on dividends in the US.

    I can see for a non-US based investor how this would make a difference.

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  6. Alex,

    I wanted to answer your question #1. I agree that at times companies can expand margins at the expense of future profits and that's a concern. In the case of Corticeira I'm not sure if that's true or not, from the sound of the report it didn't seem so, but one can never be sure.
    On the other hand the margin issue I am concerned about is how are margins impacted if costs continue to rise. Management stated that fuel costs are concerning along with supply costs presumably for the cork composite products.

    Nate

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  7. Great write up. One additional macro factor: companies in Portugal, Italy, Ireland, Greece, Spain that are heavily export driven (and do not export to weaker EU nations), will benefit from a weeker Euro. My thesis is that in the long run (2012 - 2013) one or more of the above countries could default on their debts and potentially decide to withdraw from the EU in order to devalue their currencies (and therefore their debts). This type of a disaster event would temporarily depress the entire market but would be great for high quality exporters.

    Heavily indebted countries will always devalue their currencies (even the US is going to go down this road). So I like your pick from a macro angle.

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