Price: €56 (4/22/2012)
I want to start this post with a small discussion on how I've begun to look at stocks that sell below book value and have what I'd consider average earnings power. Obviously not all companies can be valued through the same lens, but I think there are a lot of these 'two pillar' stocks out there right now. With the lack of net-net's outside of Japan, and not many actual high quality companies selling at multiples I'd consider cheap I've found myself looking at a lot of these two pillar stocks.
Two pillars of value
Long time readers will recognize that the stocks I look at fall mostly into two different buckets, the irrationally cheap (things like net-net's), and average to decent businesses selling at low valuations (cheap hidden champions for example). Throw in a few special situations and that basically summarizes most of my investments, and not incidentally most posts on the blog. I've long recognized that there's a "hole" in my style but I couldn't quite identify it or make sense of it.
The hole is what to do with an average business that's selling below book value and has decent earnings but is really nothing stellar. The answer was found in chapter 38 of the 1951 edition of Security Analysis. I want to say thanks to the reader who has pointed me in the right direction on this. This chapter was instrumental to Graham, Schloss and Cundill's investment styles. The reader who mentioned this to me is quite successful using this style, and I'm hoping to integrate it myself.
The idea is there are two pillars of value, book value and earnings power. The investor wants those two values to support each other. So for example consider a company with a book value of $10 a share that's also earning $1 per share. With a conservative multiple on earnings such as 10 or 12x the earning power $10-12 a share supports book value. What we're basically saying is since earnings is in support of or slightly in excess of the company's book value there is no reason for the stock to trade below book value. So in the case of our example if the stock was trading at $5 it's reasonable to think they should be worth $10.
The best way to describe the two pillar style of asset/earning investing is to use an example. I'm going to use Gévelot, a company that I found using the FT.com screener.
The company consists of a parent company with three wholey owned European subsidiaries. The business segments of the subsidiaries are cold extrusion, fluid technology and automotive parts such as motorcycle carburetors. Both the extrusion and mechanical division make parts for the automotive industry, the fluid subsidiary supplies parts for a variety of industries such as oil and gas.
For anyone wondering extrusion is a process of ramming metal through a die to change its shape. Gévelot specializes in cold extrusion meaning this process is done at room temperature to minimize oxidation of the metal. The company's website has some nice descriptions of the business segments in English, and I got lost on Wikipedia reading about extrusion. I worked at a metal stamping factory one summer during college so the extrusion stuff took me back a bit to that dark, greasy factory on the shores of Lake Erie...
The parent company owns office space which it leases out to the subsidiary companies. Dividends are paid out of the revenue received from rental income. The subsidiaries don't pay any dividends up to the parent level.
The business segment breakdown of revenue has been as follows:
Pillar one, book value
I mentioned above that there are two pillars of value supporting intrinsic value. Buying when these pillars agree and well below their agreed on value gives the investor a margin of safety. The first pillar comes from the balance sheet; book value.
Due to the lack of an easy recent balance sheet for Gévelot I build out my own:
There are a few things I want to highlight, the first is that working capital is very close to the current market cap for Gévelot. The company isn't a net-net, but they are trading very close to working capital. The second item is that debt to equity is reasonable at 31%. European companies tend to be more levered than their American counterparts. Even still 31% is very manageable.
The last item of note is that equity is composed of very little goodwill or intangibles. This is an important point, one of the keys to this investment is the strength of book value. If book value was composed mostly of goodwill we wouldn't have as much safety in buying below book value. As it stands Gévelot's balance sheet is composed of quality current assets, and hard assets such as manufacturing facilities.
The company's equity value is €127m, this is against a market cap of €51m a sizable discount.
Pillar two, earnings power
Gévelot is immediately enticing if you look their ticker up on any stock stat page, they have a P/E of 4.7 and a EV/EBITDA ratio of 1.7. I wanted to go a step further than just grabbing a few stats from Bloomberg.
If we take the company's earnings from the last year or two and slap a 10x multiple on them they easily equal book value. So in a simple sense we have both pillars that match, the earnings power, and the book value. I didn't want to just take a gamble and use the last year's earnings so I built out a small spreadsheet showing the operating and net earnings over the past six years. I also tossed in cash flow and free cash flow over the past five since the 2011 annual report hasn't been approved yet.
When looking at this my biggest concern is that Gévelot's margins are at an all time high and will eventually drift lower. The good news is that they're a consistent cash generating company, even in 2009 when they had a loss. Some readers will note they aren't a free cash flow machine, which is expected for such a capital intensive business. Gévelot needs to continually reinvest in their company to keep up their earnings power.
Putting it all together
The big question after looking at each pillar independently is do they work together to establish a valuation? I think they do, the following table shows how earnings power and book value are both similar numbers:
Even the low end of the range, the average earning power over the last six years is greater than the current market price. At a minimum Gévelot is worth 23% more than, and at most it's worth 178% more. I think the company is worth more than the minimum but less than the maximum which puts it in the range of €120m or so. With a possible value around €120m and a trading price at €51m I'm giving myself a pretty large margin of safety to be wrong. If it turns out that Gévelot is only worth €80m I still end up with a 56% gain which would be acceptable.
I haven't put in an order for Gévelot yet because I want to hear your thoughts, and I'm considering waiting for the 2011 annual report to be finalized. So the question I'm asking myself is...
Est-ce un bon investissement ou non?
Disclosure: No position