Lonmin Plc: Value buy or value trap?

Should you catch a falling knife?

Lonmin may be a falling knife. Beware.

Disclosure: I have no financial interest in any  company mentioned in this article.

The recent slide in commodity stocks has been uncomfortable for shareholders in many companies, but devastating for those owning shares in South African platinum miner Lonmin Plc (LON:LMI).

The firm’s shares have fallen by 54% to 57p over the last month, taking their 12-month decline to 77%.

Lonmin shares now trade at an 80% discount to the firm’s latest reported book value. In this article I’ll ask whether this is a deep value opportunity, or simply a value trap.

1. Book value

Let’s deal with the question of book value first. According to Lonmin’s interim results, the firm had a tangible net asset value of 311p per share. At last night’s closing price of 57p, that puts Lonmin shares on a price/tangible book ratio of just 0.18.

As with anything that seems too good to be true, this is.

Lonmin announced plans to suspend operations at some of its mine shafts on Friday. Unless we see a platinum bounce or the firm manages to find a way of operating these shafts at much lower cost, I suspect the value of these assets will have to be written down sharply when Lonmin’s accounts are next made up.

Most of the big miners have been forced to write down the book value of some of their assets. Lonmin’s discount to book value is, in my view, a reflection of likely impairments and the firm’s lack of profitability.

2. Cash flow and profits?

Value investing is all about finding investments that are cheap enough to offer a margin of safety — protection from permanent loss of capital.

Lonmin admitted on Friday that its operations are currently “EBITDA negative”. Translated into English, this means the firm is operating at a loss, probably quite badly. It seems fair to assume that cash flow is negative, too.

During the first half of the year, underlying EBITDA was only $8m. Since the start of Lonmin’s H2, platinum has fallen by a further 14%, from $1,126 to its current level of about $980 per ounce.

Lonmin is attempting to staunch the losses by closing the high cost Hossy and Newman shafts and focusing on the cheapest, most easily mined reserves. However, there’s no guarantee that this will be enough to return the firm to positive cash flow or EBITDA.

Based on its perilous earnings and cash flow situation, Lonmin isn’t a value buy.

3. Cash reserves?

Companies can afford to run at a loss for a while if they have a strong balance sheet, and/or cash reserves. Lonmin has neither.

The firm’s interim results showed that by 31 March, Lonmin had net debt of $282m, meaning that the firm had used up half of its $563m of borrowing facilities. Net debt is almost certainly higher today, and in Friday’s update Lonmin confirmed that it is “reviewing the appropriate capital structure” for the company in the light of “the need to re-finance our debt facilities”.

An update is expected by the time of Lonmin’s full-year results in November. Whatever combination of debt or equity is agreed on, my view is that it is likely to be heavily dilutive for shareholders, unless they are willing to put in a substantial amount of fresh cash.

As a result, Lonmin fails as a potential value investment on balance sheet strength.

Conclusion

In my view, Lonmin fails on all three core tests of value: assets, earnings and cash flow, and cash/debt.

I’m not surprised Glencore dumped its shares in the miner: as a major shareholder holding 23.9% of the stock, Ivan Glasbenberg’s trading giant was probably keen to avoid the risk of being on the hook for any cash in a placing or rights issue.

From here, Lonmin shares could easily triple or fall to zero. Buying Lonmin stock today is a punt, not an investment, in my view. As such, I’m going to continue to avoid it.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Anglo American interim results: dividend held, challenges remain

An open-cast coal mineDisclosure: I own shares in Anglo American, Rio Tinto and BHP Billiton.

Half-year results from Anglo American (LON:AAL) today coincided with another lurch down for the commodity market, but I don’t think there was anything specific in the firm’s results to single it out.

As I write, half an hour before markets close on Friday, Anglo is down 3%, BHP is down 4% and Rio is down 3.6%.

(Lonmin is down 18%, but that’s another story — one which I plan to take a closer look at in another post in the next few days. I’ve viewed Lonmin shares as toxic for the last two years, but is it time to take a punt on this firm, which trades at around a 75% discount to book value? We will see.)

Getting back to Anglo, today’s results were broadly as expected. Underlying EBIT (operating profit) of $1.9bn was 36% lower than during the same period last year. This fall was simply due to commodity price reductions, which also prompted the firm to make $3.5bn of impairments, including $2.9bn at the Minas-Rio iron ore project.

The interim dividend was maintained, to some investors’ surprise. However with the prospective yield now at 6.8%, this situation can’t last forever. Unless iron ore prices, or perhaps copper and platinum, rebound fairly soon, a dividend cut seems inevitable, in my view.

Better than expected?

The good news for shareholders is that Anglo is still profitable at an operating level. The firm also said today that it’s targeting a further $1.5bn of cost cuts during the second half, including $800m of operating cost cuts. An additional $1bn will also be cut from planned capital expenditure. These savings may go some way to help offset commodity price weakness.

Better still was news that the sale of its Lafarge business has enabled the firm to reduce net debt from $13.5bn to $11.9bn. This was much needed.

However, looking ahead in the near term, we have to accept that there isn’t much that Anglo CEO Mark Cutifani can do about commodity prices. He may also struggle to achieve an acceptable price for any asset sales, making this route unappealing.

On this basis, it makes sense to look at cash flow. Can Anglo remain self-sufficient without slipping further into debt? If so, then I may consider buying more shares and averaging down my holding.

Cash flow analysis

Let’s take a look at the cash flow statement for H1 2015 (you can see the full accounts here):

  • Net cash inflows from operating activities: $2,715m
  • Net cash used in investing activites: $2,343m
  • Net cash inflows from financing activities: $24m*

At first sight, this doesn’t look too bad and suggests that Anglo did generate some free cash flow in H1. However, that’s not really the case, at least not from an equity investor’s perspective.

I always calculate free cash flow as operating cash flow – investing cash flow – interest payments.

This is because from an equity perspective, free cash flow is only relevant if it still exists after a firm’s debt commitments have been satisifed. Remember that debt always ranks above equity. As Afren shareholders have found recently, trying to deny this basic reality can prove costly…

Anglo’s free cash flow before interest payments was $372m. Unfortunately this was wholly absorbed by interest payments of $456m. There was no free cash flow to fund the $876m of dividend payments made during the period.

However, Anglo’s financing cash flows show that borrowing fell by a net $545m during the first half, and that the firm issued $2,159m in new bonds. We also know that net debt fell by $1.6bn after the half-year ended, thanks to the Lafarge sale.

The net effect of these refinancing activities has been to reduce short-term debt and moderately increase long-term debt. Pushing repayment dates further into the future is sensible, especially given that the firm’s newer borrowings may be at lower rates than the retired debt. I’d expect Anglo’s interest payment for H2 to be slightly lower than H1.

I’d also hope that some of the firm’s targeted operating cost savings of $800m will feed through to operating cash flow in H2. However, offsetting this will be the full impact of recent commodity price falls, many of which took place towards the end of the first half. Unless prices rebound during H2, my view is that operating cash flow is likely to fall again during the second half of the year.

The verdict?

It’s a complex picture with a number of moving parts. Assuming commodity prices don’t fall much further, my feeling is that the gains and losses will broadly offset each other during the second half. This will give a similar picture to that which we’ve seen today — cash flow breakeven excluding dividend payments.

Anglo does still have more than $7bn of undrawn borrowing facilities, so it isn’t going to run out of cash. However, it makes no sense for the firm to to use borrowed money to pay dividends for more than a short period.

I’m tempted to average down on Anglo next week, but will mull it over during the weekend before making a final decision. The big risk, of course, is that we haven’t yet seen the bottom for commodities…

N.B. 27/07/15: I’m not going to average down on AAL for now, as I don’t want to go any more overweight in commodities than I already am. But I would be tempted to expand a smaller position.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Q2 2015: Quarterly review of my value portfolio

A share tip circled in a newspaper share listingDisclosure: As this is a review of my portfolio, I own shares in all of the companies mentioned except those listed as recent sales.

Quarterly reporting can sometimes make investors (and companies) focus too closely on short-term performance anomalies, but I think it’s useful to take a look at your portfolio once a quarter and assess what’s changed over the period.

I made several changes to the value portfolio during the last quarter, too, some of which have proved to be slightly poorly timed, given the recent downturn in commodity stocks.

Stocks marked with a * were bought during Q2.

Barclays

My view on Barclays (LON:BARC) remains the same: the bank is making slow but steady progress towards recovery and remains an attractive value buy. The shares remain at a c.25% discount to book value, the yield is 3% and rising and a forecast P/E of 11, falling to 9 in 2016, is undemanding.

Added to this is the catalyst that may be provided by the arrival of new chairman John McFarlane. I looked at this in more detail in a recent Motley Fool article.

Although it happened after the period end, the rapid dismissal of CEO Antony Jenkins makes it clear that Mr McFarlane will take no prisoners is his attempt to repeat the success he had at Aviva.

Barclays remains a buy, in my view.

Wm Morrison Supermarkets

Wm Morrison Supermarkets (LON:MRW) appears to be making progress with its recovery. The firm’s interim statement in May suggested that the decline in sales is being arrested and that the strategy of reducing promotional activity and simplifying the product range is ongoing. The number of SKUs fell by 8.3% last year, while promotional activity has fallen steadily.

Of course, we don’t know how all of this is affecting margins, but cash flow seems reasonably healthy, based on the £150m reduction in net debt reported during the last quarter.

I do have concerns, though. While I am convinced that the big supermarkets have a future, I don’t think they have really started to address the issues of overcapacity and incorrect store mix which seem to be at the root of the big firm’s problems.

For now, Morrisons remains a hold in my portfolio (at a modest profit), but in all honesty I wouldn’t buy the shares today.

BHP Billiton

BHP Billiton (LON:BLT) shares have been battered by the recent commodity downturn, but I’m not really bothered. The income appeal remains solid and BHP’s assets are high quality. Cash flow from iron ore remains strong and will underpin the firm’s profits. Profits from petroleum will be down but costs have been cut and the long-term outlook seems fine, to me.

We’ll learn more when the firm’s full-year results are published on August 25.

BHP remains a buy, for me.

Fenner

Fenner (LON:FENR) half-yearly results contained few real surprises. Trading conditions have worsened slightly but nothing fundamental has changed. Earnings per share are expected to fall by around 5% this year and 10% next year, leaving the shares on a 2016 forecast P/E of 13.

However, cash flow remains healthy, cost-cutting is progressing and capex is expected to fall from next year as investment in the firm’s AEP business falls.

I expect the dividend to be left unchanged, giving an attractive 6% yield on my purchase price.

Fenner remains a buy, for me.

Standard Chartered

The appointment of US investment banker Bill WInters as the new CEO at Standard Chartered (LON:STAN) galvanised the bank’s share price, but we’ve yet to learn much about Mr Winters’ plans.

StanChart shares continue to trade in-line with tangible book value and look cheap on a PE10 of about 9.5. I’m happy to hold while we wait to learn more about Mr Winter’s plans, and continue to see the shares as a buy.

Lamprell

My purchase of Lamprell (LON:LAM) was fortuitously timed, as the share price took off soon after my March buy.

I did consider selling for a quick 20% profit but have decided to hold, as a PE10 of 9.2, a strong order book and a positive outlook suggest to me that there could be more to come.

South32*

My decision to hold onto my newly-acquired South32 (LON:S32) shares looks misguided in the short term, as the shares have fallen by 28% from the high of 120p seen shortly after they were listed.

However, the amount of money involved is relatively small so I’ve decided to take a punt and see how this story develops over the longer term. There’s takeover potential and I’d like to see a full set of financials before making any further decisions.

Hargreaves Services*

Perhaps my riskiest and most controversial stock, coal mining, trading and logistics specialist Hargreaves Services (LON:HSP) is undoubtedly going through an existential crisis. Low coal prices mean that the majority of its mining operations have been shut down or mothballed. The diminishing number of coal power stations in the UK also does not bode well.

However, I was attracted by management’s pragmatic approach to slimming down operations and their ability to generate free cash flow from their asset base. This has resulted in a very strong balance sheet and high yield. There are property assets, too, which could deliver value in the medium term.

The market didn’t react well to the year-end trading update and with hindsight my purchase was mis-timed. At the time of writing I’m down 26%. Yet the shares currently trade on just 7 times 2016 forecast earnings and offer a yield of nearly 10%.

This is a special situation and there is a risk that my fat dividends will be obliterated by a crumbling share price. But for now, I’m happy to hold.

Flybe*

Flybe (LON:FLYB) is another special situation/turnaround play. The situation is clear: the underlying airline business is profitable and modestly valued. At the time of my purchase the shares traded on 8 times underlying profits, and even after recent gains the share price is still less than 10 times underlying profits.

But there’s an albatross around the firm’s neck: seven airplanes the firm must pay for but cannot use. These could cost £26m, if a commercial purpose cannot be found for them.

Flybe started out with 14 of these planes and has so far reduced the number to 7. It’s well funded after last year’s placing, with net cash of around £50m. The firm’s latest results, released a few weeks ago, confirm that the remainder of the business is working well.

I believe the airline will find a solution to its surplus aircraft problem, whichi should trigger a further re-rating of the shares.

On that basis, I hold.

Anglo American*

I’d had my eye on Anglo American (LON:AAL) for a while, hoping for a chance to buy below 1,000p. At the time of my recent purchase, Anglo shares traded on a PE10 of 5.9, a price-to-book ratio of 0.65, and offered a trailing yield of 5.7%.

As you may have noticed, the downturn in the commodity market has sharpened markedly over the last month. My purchase at 968p is now underwater, with the shares trading at 874p. However, I remain comfortable with the situation and in my view, Anglo remains a buy.

Shoe Zone*

At the time of my purchase, just before the end of June, I said this about budget footwear retailer Shoe Zone (LON:SHOE):

Shoe Zone appears to be cheap, profitable and cash generative. Its balance sheet looks strong and the shares have an attractively high dividend yield.

With a forecast P/E of 9 and a prospective yield in excess of 6%, nothing has changed since then. The firm’s share price stayed firm through the recent market volatility, which I take as encouraging sign.

Shoe Zone remains a buy, in my view.

IndigoVision Group*

The most recent addition to my portfolio is CCTV specialist IndigoVision Group (LON:IND), which just squeezed into my portfolio on the last day of the quarter.

This is a smaller company than I would usually invest in, but I was attracted by the apparent quality and value in the shares, and the likelihood, based on historical performance, that the firm’s earnings will recover from this year’s disappointment.

In short, this is a company that suffers from lumpy earnings. The shares trade on a trailing P/E of about 8 and a forecast P/E of about 11.5. IndigoVision has net cash, a dividend that’s covered by free cash flow and a six-year average return on capital employed of almost 15%.

Like Shoe Zone, IndigoVision’s share price has remained stable despite recent volatility.

Finally — the ones I sold

I sold two stocks during the last quarter, Tullett Prebon and Petrofac.

I sold Petrofac (LON:PFC) in April for a small loss because looking back over the last few years’ accounts, left me unsure about the firm’s ability to generate free cash flow. You’re right, I should have done this before I bought.

I sold interdealer broker Tullett Prebon (LON:TLPR) because it no longer seemed to be anomalously cheap, which was the reason for my investment. With a profit of more than 40%, I was happy to bank my gain and move on. I’ve written a longer explanation of why I sold my Tullett shares here.

As always, I’d love to hear your thoughts about any of the shares in my portfolio. Please leave a comment below or reach me on Twitter @rolandhead.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

Will IndigoVision stay true to form and rebound?

CCTV security cameraDisclosure: I have no financial interest in any of the companies mentioned but intend to buy shares in IndigoVision within a few days of the publication date of this article.

Small cap IP video security specialist IndigoVision has a history of inconsistent performance, which appears to be due to the lumpy nature of its orders.

This is a fairly common problem with small caps, but means that the firm appears to veer between profit growth and profit warnings with some regularity.

While frustrating for long-term shareholders, this does appear to present an opportunity for value investors. Indigovision has a strong balance sheet and has historically generated attractive returns on capital.

Buying when the shares are cheap and waiting for earnings to recover could be a sound strategy.

Is now the time?

I mention this now because IndigoVision’s last update to the market was a profit warning. The shares have fallen by 35% so far in 2015 and by 52% over the last year. IndigoVision stock currently trades at a post-2011 low of 230p.

This leaves the shares trading on an attractive historic valuation, given last year’s strong results*. Here’s the usual extract from my investment spreadsheet, which I populate when reviewing a company with a view to adding to or selling from my value portfolio:

TTM P/E TTM P/FCF TTM yield PE10 P/B P/TB P/S Current Ratio Dividend cover FCF dividend cover Cash interest cover Net gearing
8.40 10.40 3.30% 15.2 0.9 0.91 0.35 2.4 3.5 1.8 1109 -10.20%

*IndigoVision reported results over 17 months in 2014, in order to move its accounting year-end to 31 December from 31 July previously. To get 12-month figures, I’ve crudely normalised last year’s earnings and free cash flow by multiplying the reported figures by 12/17.

In keeping with my increasingly quantitative approach to investing, I am placing a lot of emphasis on the historical numbers. After all, nothing fundamental has changed in the business, so there is no real reason to think that this level of earnings cannot be regained.

Historic growth and forecast earnings?

I don’t completely ignore the outlook for a stock or its past performance. Here’s how things stand at present (30/06/15) for IndigoVision:

Fwd P/E Fwd yield 5-yr average ROCE 10yr eps growth 10-yr divi growth
12.1 2.75% 13.80% 0.40% 6.20%

You can see that while long-term return on capital employed (ROCE) and dividend growth are strong, earnings per share growth is not. However, due to my (hopefully) well-timed entry at a low point in IndigoVision’s cycle, this may not be an issue.

What about the story?

I’m not a purely quantitative investor.

My investment spreadsheet also contains a section of note, where I provide note down the context and my moderately subjective interpretation of the figures above, plus my investment decision.

I ensure that I have a general idea of what a company does and any obvious problems or opportunities it faces. In IndigoVision’s case, I like that its revenues are widely distributed across a global customer base in many industries.

I also see the merit in its video over IP (Internet Protocol) approach, which (for non-techies) means that everything is digital and can be integrated with the firm’s powerful analytics and management software. InidigoVision’s products can operate over any standard data or mobile broadband network, making connecting up remote locations a doddle, I’d imagine.

However, I try not to predict the future in too much detail. This is a pastime for growth investors, in my view.

I prefer the traditional value investing approach of buying a proven good business at a low price, and then waiting for something good to happen.

It’s with this in mind that I plan to buy shares in Indigovision in the next day or two. When I do, I’ll add details of my holding to my value portfolio.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.

3 reasons why it may be too late to invest in housebuilders

HousebuildersDisclosure: I have no financial interest in any of the companies mentioned.

The big housebuilders have proved to be a spectacular investment. Barratt Developments, for example, has risen by 500% in five years.

Even if you were late to the party and only invested one year ago, you would still be up by almost 75% at the time of writing.

Of course, housebuilders are cyclical businesses.

Bulls tell me that they remain reasonably priced, but I’m not convinced. I believe housebuilders are starting to look expensive.

Indeed, while housebuilders’ profits may continue to rise for a little longer yet, I reckon the warning signs of an advanced bull market are starting to appear.

1. Gazumping

If you live in the south east, you’re probably familiar with the reality of home buyers gazumping each other. It’s when a seller reneges on a previously agreed deal to accept a higher offer from another potential buyer.

What you might not realise is that this is starting to happen among developers and builders, too.

Last week, small cap housebuilder and developer Inland Homes announced a £19m land sale to “a major housebuilder”. The sale was for 205 residential plots, with planning permission, at the firm’s Drayton Garden Village project.

The interesting this about the sale was that in March, Inland reported being “very advanced in our negotiations with a substantial institutional investor in the Private Rented Sector” for the sale of the same plots.

According to Inland, these discussions were suspended as a result of “the significant offer received from the major housebuilder.” That sounds like large-scale gazumping, to me. The housebuilder was willing to outbid another major buyer to secure the land.

2. Affordability is plummeting

Affordability is now nearly as bad as it was at the peak of the last boom, in 2007/8.

The grim reality of this situation was brought home to me in a recent blog post on John Kingham’s excellent UK Value Investor website.

Like me, John very much relies on quantitative methods to determine whether an investment is cheap or expensive, rather than sentiment or subjective views on the future. John points out that according to the Halifax house price index, house prices are currently 5.1 times higher than the average earnings of home buyers.

That’s considerably above the long-term average (since 1983) of 4.1, and closing in on the 2007 all-time high of 5.8 times earnings. As John points out:

Since 1983, the UK housing market’s price to earnings ratio has been lower than it is today more than 87% of the time. The only time the ratio has been higher was during the absolute peak of the pre-financial crisis property boom.

The reality is that house prices have been supported by low interest rates and the outrageous and reckless use of taxpayers’ money (via Help to Buy, for example). Liquidity in the market has also fallen, as the ‘haves’ — existing homeowners — opt to stay put rather than sell for lower prices.

The final ingredient required to support prices has been the booming private rental market, which provided housing for the rapidly rising number of people who cannot afford to buy. This too has been supported by taxpayers’ money, in the form of housing benefit.

These trends won’t continue forever. At some point, house prices will weaken or stagnate. Otherwise, the housing market will shrink to include only an affluent minority of the population…

3. Land prices rising?

My third point is that people with decent land to sell are reporting strong growth in profits from land sales to major housebuilders.

Back in March, listed developer Henry Boot reported a 26% rise in operating profits from land development. That means buying land and developing it to the point of planning consent, before selling it onto major housebuilders.

Results like this suggest to me that housebuilders are buying more land and paying more for it.

A classic top?

In the UK at least, housebuilding is and will probably always be heavily cyclical. On the upward leg of the cycle, house prices rise, demand grows and housebuilders increase the number of houses they build. Share prices and dividends (a.k.a. cash returns) rise rapidly, as we’ve seen recently.

At some point, demand is satiated and/or prices start to become unaffordable, which dampens demand. Housebuilders are then left with more houses to sell than they really need. They are forced to cut prices to sell completed stock and — naturally — slow or pause their pipeline of new developments. Share prices and dividends fall rapidly, as we saw after 2008.

At the bottom of the cycle, housebuilders can be found trading for less than the book value of their land and completed houses. That’s the time to buy, in my view.

Current valuations of more than two times book value hold no appeal for me, however high their accompanying dividend yields might be. P/E valuations are largely meaningless, as housebuilders earnings are not sustainable or stable over a 5-10 year cycle.

I’m certain we are getting close to the top of the market, but that doesn’t mean we’re there.

It could be three months or three years. In fact, that range of time would be my best guess.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.