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%

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.

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%

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.

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 work better.

A structural bottleneck in the South African equity market is the reality 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 inadvertently pushed to cover the more liquid counters in this universe in order to effectively monetize their research through the related, generated and allocated trade.

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 small cap counters that fall just off this radar.

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

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

This solves numerous challenges: (1) Investors and the general market can benefit from freely available professional research on these under-covered stocks, (2) the small caps can feel the benefit of professional coverage, and (3) the research is sufficiently monetized to justify the time, effort and expense in building and maintaining it.

Essentially, this is Blue Gem Research’s rationale.

Besides this public-facing research, Blue Gem Research also provides exclusive independent research to certain, invite-only buy-side and related houses. Our client list is limited to a maximum of only five houses. The reality is that the illiquidity of the local small cap market does not lend itself to mass sell-side research and our choice to provide exclusive independent research is based predominantly on the liquidity constraints and alignment of methodologies of the buy-side houses we have allowed onto our subscription list.

Please spend some time familiarising yourself with our approach, ethics and the various channels you can follow, like and subscribe to us and our research.

Firstly, in our Methodology page we go into quite a bit of detail regarding our research approach, valuation techniques and unique insights into the local small cap market. To best understand our research reports, you need to understand our approach to investing. There are links to videos and webinars we have presented and this page also includes some key terminology we use as shorthand in our research reports. The odds are that if anything you read in our research confuses you, you will better understand it after referring to this page as background.

Secondly, in our Frequently Asked Questions page we answer some of the most common questions thrown at us regarding Blue Gem Research, prepaid research and various other details. Perhaps just browse through this page if you have any questions relating specifically to Blue Gem Research.

Thirdly, Blue Gem Research has some firm convictions regarding ethical conduct in the stock market. Besides all the standard ethics applied in the research environment in South Africa (which we strictly apply!), we would like to emphasise three key (and in some sense, unique) ethical principles we also believe in. Read about them in our Ethics page.

Fourthly, our Disclaimer page discloses some of the finer legal details of our research. While it may be a boring read, it is quite important that you understand our global disclaimer. By browsing this website and its research, you are assumed to have read, understood and agreed to this disclaimer.

It must be noted, though, that Blue Gem Research operates with the feel-good intentions of trying to make the market work better. It is our belief that quality research should, as far as possible, be freely available. Please do not distort our good intentions, but take them, interpret them and use them with this in mind. The only people who get rich when “the lawyers” get involved are “the lawyers” and we, personally, would prefer to live in a world filled with poor lawyers.

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Keith McLachlan