If you leave your suggestions in the comments section then I’ll fashion them into a short post in the very near future. Extra brownie points if your suggestion is a FTSE 350 member.

In summary, I view Euromoney Institutional Investor as a well-diversified business with interests in a large number of leading publications and services. Fixed asset and working capital requirements are negligible, allowing the company to generate a large amount of cash flow, which I would expect to continue to be used for dividends and acquisitions. The market for ERM’s services grows over time as businesses seek to expand by increasing their own market knowledge and that of their staff. Competition is present, but a number of factors are at work which somewhat insulate ERM from the full force of the free market. The price of the business is cheap as well, with the key price/cash-flow ratio modest at only 9.5x.  My key concerns about the business are: (1) how the transition to the internet impacts the publishing division; (2) the volatility of the share price given the large component of advertising/sponsorship revenues; and (3) the blocking stake held by DMGT plc which prevents shareholders from benefiting from a takeoever battle.

Since I wrote that piece three things have occurred; firstly, the Euromoney Institutional Investor plc share price has fallen from 698p to 649p at the time of writing (-7%); secondly, the company has continued to report strong trading, both 1H11 results and an interim management statement; and thirdly, the company has made an small acquisition.  As I see it, these changes strengthen the investment case and I have responded by putting together a discount cash flow model.

With regards to the company’s results, in 1H11 the company reported revenues of £168m, 13% higher than a year earlier, driven by conference sponsorship revenue, which increased by 35%.  However, the publication subscription revenue (which makes up nearly half of revenues) also performed well, growing by 12%yoy.  Before a £4.7m management incentive expense which didn’t occur in the prior period, operating profit increased by 9.7% vs 1H10.  Cash flow of £32m was down from £39m in the prior period, though this was due to a £19.3m tax bill vs almost zero in 1H11.  However, cash flow was applied to debt reduction, which fell to £103m vs £129m at Sept-10.

This strong performance continued into the third quarter, as ERM stated in its Interim Management Statement that revenues (on a constant currency basis) had increased by 10% vs 3Q10 to reach £102m.  This represented a slight slowdown from the 13% growth reported in 1H10, but still respectable.  The outlook statement provided as part of the release suggests that more recent trading has continued to be challenging, though it is good to know that advertising and delegate revenues have recently picked-up:

Since the start of June, there has been a pick-up in advertising sales and in delegate bookings for the training division. However, revenue visibility for September, which traditionally accounts for at least 20% of the group’s full year profit, is limited as usual at this time. July and August are the quietest trading months of the year, and the fourth quarter is the least important for the group’s event businesses. Nevertheless, despite the market concerns over fiscal risk and economic growth, the board is confident its strategy for investing in digital publishing and in acquisitions will continue to drive revenue growth.

Another positive contained within the results release was that the company continued to generate cash during the quarter, with net debt falling to £73.8m from £102m at the beginning of the quarter.  Therefore the enterprise value is now £855m, versus £948m in February, a decline of 9.8%.

On 20th June Euromoney Institutional Investor announced that it had agreed to acquire 87% of Ned Davis Research Group, a US-based provider of financial research for institutional investors.  ERM agreed to pay $112m, which values the company at 10.9x FY10 pre-tax profit.  The remaining 13% of the company is subject to an earn-out agreement.  The transaction will add approximately£69m to net debt, taking it back up to £143m.

My free cash flow to the firm model, which uses a cost of equity of 12% and a terminal growth rate of 3.5%, values the company’s shares at 1,008p each, a 55% premium to the current share price of 649p.  The model can be downloaded here and the key table is shown below.

Click to embiggen

The main assumptions used within are as follows:

• Revenue growth of 9.5% in  FY11 (to £361m), fading to 4% per annum by FY18.
• Gross margins of 75% in FY11 (up from 74.1% in FY10) and constant thereafter.
• Operating profit of £87m in FY11 (£45m earned in 1H11), with SG&A constant as a proportion of revenues thereafter.
• Interest rate of 7.5%.
• Tax rate of 18%, in-line with historical average.  This is one risk in the model – that the tax rate increases towards the statutory rate.
• Working capital days constant at -659.
• Capital expenditure of £4m in FY11, growing in line with revenues thereafter.

• 4Q11 revenue identical to that reported in 3Q11.  Year-on-year revenue growth in each year thereafter of 20%, 15%, 10%, 7.5%, 5%, 5%, 5%.
• 40% gross margins for FY11 (currently 41% after three quarters), declining to 36% by FY18.
• SG&A and R&D to remain constant as a proportion of revenues.
• Tax rate to remain constant.
• No interest earned on cash balance (for simplicity).
• No borrowings, no dividends, no acquisitions, no disposals.
• Cost of equity capital of 10%.
• A terminal growth rate of 2% per annum.

Scottish Parliament: Image via Wikipedia

On 5th May 2011, the first time since devolution in July 1999, the Scottish National Party won a majority of seats in the Scottish Parliament at Holyrood.  One of the key manifesto promises of the party is to hold a referendum on Scottish independence before 2016.  While political commentators have begun discussing the potential political ramifications of this – and how to stop it from happening, I’ve seen very little written on the financial and economic issues that will be raised as part of a break-up of the United Kingdom.  Those pieces that do touch on economics tend to focus on the fact the UK Treasury currently receives Scottish oil revenues and Scotland receives higher per capita public spending than England.  These two factors probably net-off to near zero.  I believe that there are more important issues at hand.

The first of these is what will happen to the national debt?  At present, the national debt of the United Kingdom is £921bn, which compares to FY10 GDP of £1,455bn, to give a debt to GDP ratio of 63%.  So how will the national debt be split?  Presumably Scotland will not be able to walk away from this debt and leave it with the rest of the United Kingdom (this would leave England, Wales & Northern Ireland with debt/GDP of 69%)?  The most democratic way to split the national debt is on a per capita basis; however, this is unlikely to be popular with the Scots, as their lower GDP would leave the new country with debt/GDP of 67%.  This leaves the most viable political strategy as splitting the national debt on a pro-rata basis to GDP (ie both Scotland & England/Wales/NI would have debt/GDP of 63%).  However, there are other questions to be answered, such as: (1) how should nuclear decommissioning liabilities be calculated and assigned; (2) what about debt incurred by quasi-governmental organisations such as National Rail; and (3) how would public sector pension liabilities be shared-out?  The political and economic calculations are highly complex.  Regardless of the exact mechanics of this, people who have invested in Gilts – UK Government bonds – are going to find themselves holding two separate pieces of paper, one worth approximately 92% of par – a liability of England, Wales & Northern Ireland; and one worth ~8% of par – a liability of the new Scottish nation.  Given the large number of different Gilts with their separate maturity dates and coupons, investors could find that their new Scottish securities are much less liquid than the Gilts that they used to hold.  Would there be an immediate “flight-to-quality” (or liquidity) away from the new Scottish bonds and into English obligations?  The extent to which this occurs will depend on the answer to the next question.

One of the first issues sitting in the in-tray of a hypothetical Scottish government will be to make a decision about what currency to use.  As far as I can tell, they would have three possible options: (1) continue to use pound sterling issued by the Bank of England; (2) join the Euro-zone; and (3) issue a new Scottish currency.  The first two have very similar problems, namely the arguments often regurgitated against the UK joining the Euro-zone.  As a reminder of these, one major issue is that Scotland would lose control over its exchange rate and monetary policy, meaning that without significant convergence with the core of the Eurozone (ie Germany) or England, major imbalances could develop – either an investment boom and consequent bust (as in Ireland or Spain) or stagnation and gradual debt build-up (as in Greece, Italy and Portugal).  While it could be argued that Scotland is “converged” with England today, that may well change should an independent Scotland begin to pursue its own fiscal policy and/or oil prices change materially, increasing (or reducing) the new Scottish government’s income from energy.  This is particularly the case given Alex Salmond argues Scottish independence would lead to improved economic performance – effectively an acknowledgement that the economy would diverge from that of England.  The second issue – closely linked to the first – is that the Scottish government would not be an issuer of its own currency.  The result is that its bonds would be subject to default risk, which would likely require a higher interest rate than do Gilts at present.  Governments that issue their own currencies can never default, as they can always print more currency if necessary.  Such printing of banknotes does devalue the currency, but tends to be much less catastrophic than a liquidity-driven default.  For example, the Pound has lost about 95% of its value since WWII, but the economy has grown many times over during the same period.  Should the Scottish government decide to issue a new currency, the difficulty would be that with no track record, the new currency would likely immediately depreciate from an expected 1:1 exchange rate with pound sterling.  This is because a new currency of a relatively small country would have no track record, and investors would demand a higher rate of interest to hold it as an alternative to pound sterling, a minor reserve currency.  Therefore, the Scottish monetary authorities would be faced with the choice of hiking interest rates to maintain parity – thus strangling economic growth – or allowing the currency to depreciate, increasing the real value of debts denominated in pound sterling and increasing the cost of imports for Scottish consumers – thus reducing the standard of living.  Not only is Scottish independence no economic free lunch, but it is likely to come at a cost.

Another key issue, in my opinion, is what would happen to the UK government holdings in Scottish domiciled and Edinburgh-headquartered Royal Bank of Scotland plc.  At present the United Kingdom government owns 83% of the equity in the bank, has provided £222bn of credit insurance on risky assets via the Asset Protection Scheme and the Bank of England has made available approximately £16bn of debt-funding under the Special Liquidity Scheme.  In my view, I don’t see how it would be politically feasible for a bank so systemically important to the English economy and owing such significant sums to the English taxpayer (as it would after Scottish independence) to be headquartered and domiciled in another country.  Indeed, given the size of RBS in relation to the English economy, I would go as far as describing the bank having all its key decision-making functions located in another country as a major risk to English economic security.  The solutions to this are two-fold: (1) RBS moves its domicile and all the key decision-making functions to England; or (2) The new independent Scotland buys-out the English government’s share of RBS’s equity and liabilities.  At £16bn for the equity, £15bn for the Special Liquidity Scheme and a £200bn contingent liability under the Asset Protection Scheme I think the second option is unlikely given Scottish GDP is only £115bn (and therefore the upfront cash payment required from the new Scottish government would be 27% of GDP).

In summary, I believe that Scottish independence could have profound implications for the owners of gilts, and that those implications will depend very much upon the currency policy selected by the government of the newly-independent Scotland.  An independent Scotland will have a major decision to make about which currency to use – none of the options look particularly attractive and all are likely to lead to higher public borrowing costs than the UK achieves on gilts at present.  Finally, an independent Scotland is likely to lose RBS headquarters (a major employer in Edinburgh) to England, assuming of course that RBS hasn’t fully-paid back the UK government and Bank of England on its equity and liabilities.  Therefore, there are some major issues for the Scottish people, politicians and UK government bond investors to consider during the next few years.

1. Stock/flow errors.  This is usually the mistake of journalists and politicians rather than professional investors, though is still far and away my biggest pet hate due to the basic nature of the error.  For those readers not familiar with the concept, a stock is a measure taken at a specific point in time, while a flow is a measure of a change in a quantity during a particular time period.  Anything measured “per second”, “per day”, “per month” or “per year” is a flow.  For example, Lake Baikal is estimated to contain 23,615cu-km of water, while the River Amazon has an estimated discharge of 209,000cu-m/second.  The former is a stock and the latter is a flow.  The first error is simply to misunderstand which is the stock and which is the flow – I’ve lost count of the number of times I’ve heard UK Members of Parliament confuse the budget deficit (a flow) and the national debt (a stock).  The second major error is to compare one stock to another flow, like this example that compares Apple Inc‘s cash & investments (a stock) to the GDP of countries (a flow).  This is a nonsensical comparison from which no conclusions of any value can be drawn.  If you really did want to compare a company a a country, then comparing net profit plus employee costs (for the company) with GDP (for the country) would be the correct approach as both are flow concepts that measure value-added per annum.
2. Assuming That Strong Long-Run Economic Growth Projections will translate into Strong Long-Run Equity Performance.  Even the professionals fall into this particular elephant trap.  I regularly hear or read something along the lines of “I recommend people invest in Chinese/Brazilian/India shares as these countries are going to see exceptionally strong economic growth in the coming decades”.  Even if the individual is correct is predicting the economic growth (which could turn out much lower than expected – just take a look at look-term projections for Japan that were made in the 1980′s), long-run empirical studies – such as this one - have shown how there is no link between economic growth and equity returns.  Why?  Because economic growth that occurs due to increasing education and rising populations benefits labour, not capital.  Secondly, economic growth that occurs due to long-term capital accumulation has little benefit for the owners of today’s fixed capital (indeed, new capital investment competes with existing capital, driving-down returns).  This is exhibited through the issue of new additional equity on the stock market in question – a hypothetical investor who owns an index-tracking fund will see his percentage interest in the nation’s capital diluted over time as new companies are born and later issues shares.  Thus, much of the returns that do accrue to capital go to entrepreneurs, not stock market investors.
3. The UK Government “Helping” first-time home buyers.  This is another one that really gets my goat.  The problem with “helping” buyers is that it increases demand, or to economists, shifts the demand curve outwards.    This results in higher house prices, but a negligible increase in supply given the inelasticity of the supply curve (due to the lack of available land for house-building).  Chief among such policies are government-subsidised shared-ownership schemes, which funnel taxpayer cash towards a lucky few who’re able to meet the predetermined criteria.  This reminds me of the famous scene from the film “This Is Spinal Tap” – embedded below – where Nigel Tufnel explains to Marty DiBergi that their amplifiers “go up to 11″ and fails understand the response that the same amp re-badged with “10″ would sound exactly the same.  Current government policy will simply lead to more expensive houses and a near-identical number of people without a home, a re-badging of the the house-price amp from 10 to 11.
   
   If the government really wanted to help potential house-buyers, then the best way would be to make the amplifier louder and implement policies that bring about an increase in supply.  This would most likely involve relaxing planning laws to enable more houses to be built.
4. Personifying the markets.  This is a favourite of financial journalists and socialists alike, who see financial markets markets as a single living and breathing beast, rather than the sum of many thousands of small decisions made by different investors all around the world.  Consequently, headlines likes “shorts attack country X” or “locusts feed on company Y” don’t make any sense at all.  Financial markets are more like the movement of water under the influence of gravity – money flows into profitable opportunities in the same way that water always flows to the lowest possible point.  No emotion is involved and no overall “decision” is made.  Thousands – if not millions – of investors acting in their own interests leads to the final outcome, just like millions of water molecules under gravity.
5. Comparing relative value metrics with their historical levels with no reference interest rates.  I regularly read pieces that refer to the current price/earnings ratio (or other metric) at which the stock market is currently trading, which is then inevitably compared to its long-term average.  What these pieces inevitably miss is that the long-term average is a misleading measure, as interest rates have not been consistent over the long-term.  The chart below, which plots the S&P’s current price divided by 10-year average earnings, shows how the current level is well-above the long-term average of 16.4x.  However, what it fails to show is that interest rates are currently at a near-record low.  Investors should be willing to pay a higher multiple of earnings for shares when interest rates are low then when they are high as a lower interest rate means a higher present value of future earnings.  Therefore, simply comparing a P/E ratio to its historical average fails to capture this critical piece of information.  I discuss how interest rates should impact the calculation of the justified P/E ratio in this previous post.
   Source: http://www.multpl.com/

Listed on the London Stock Exchange (LON:CKN) Clarkson plc, recently covered by Valuhunteruk, describes itself as:

Clarksons are the world’s leading provider of integrated shipping services, bringing our connections and experience to an international client base. We play a vital intermediary role between shipowners and ship charterers across every sector of maritime trade. Our network of offices spans five continents and our services and expertise help ensure the smooth and efficient functioning of global seaborne trade.

Ship-broking is the main-stay of the Clarkson business, generating 84% of group revenue.  The company also provides port services, research on shipping markets and financial services related to the shipping industry.  Although these services generate 16% of the group revenue, they make almost no profit, making the business entirely reliant upon the broking division.  However, the broking division is itself highly diversified, encapsulating dry bulk, container shipping, crude oil, gas, specialised products and oil rigs, as well as negotiating the trading of second-hand vessels and arranging new-build contracts.  In addition, the revenue base is well-diversified geographically, with 75% coming from across Europe, Africa and the Middle East, 18% from Asia-Pacific and 7% from the Americas.  The ship-broking industry is a relatively small niche which is dominated by a handful of Baltic Exchange member firms.

The company has an good track-record, having grown revenues from £115m in FY05 to £202m in FY10 (a 12% CAGR), though operating profits have not kept pace with this (growing at 7% per annum from £24.8m to £34.5m) as margins have been squeezed over time, shrinking from 21.5% to 17%.  However, it is through cash generation that the company has really delivered an excellent performance, with equity free cash flow (defined as cash from operations less capex) increasing from £9.7m in FY05 to £39.4m in FY10, a growth rate of 32% per annum.  During these last six years, equity free cash flow has averaged £22.1m, which is equivalent to 9.5% of the current market capitalisation.  This strong cash generation is due to negligible capex needs – Clarkson is a people-based business and these individuals need only offices, computers and telephones to be able to do their jobs.  The other positive characteristic is a negative working capital position (ie, payables are greater than receivables) as employees (the key outgoing) only get paid their bonuses long-after customers have paid their bills.  Consequently, the business should generate rather than consume cash as it grows.  The downside of this is that during a downturn, Clarkson may be required to pay-out employee bonuses for previous out-performance, as it did during FY09, which led to a £19.8m cash outflow.

Clarkson has a rock-solid balance sheet, with £176m of cash and only £44m of debt.  Even after deducting cash set aside for employee bonuses (recorded in the payables balance), the company still has a net cash position of £61.7m.  Given the company has almost no capex needs, negligible operating lease commitments and a near-fully-funded pension fund, this cash balance is in my opinion large enough to protect the company against another downturn of the type experienced in FY09 (when the company saw a cash outflow of £19.8m) and provides scope to make a one-off large pay-out to shareholders.

Based upon the current share price of 1247p, Clarkson trades at 9.9x FY10 earnings, 2.4x book value, at an EV/EBITDA ratio of 4.5x, and at an equity free cash flow yield of 17% (9.5% as a six-year average, 12.8% as a six-year average on a cash balance-adjusted basis).  These metrics all appear to imply the company is incredibly cheap, especially for a business that has consistently grown revenues, earnings and dividends over time.  However, we can see from the chart below that Clarkson has traded at a low P/E for a number of years (the ratio only expanding during the recession as investors priced-in a quick rebound in earnings).  This suggests that a sudden re-rating of Clarkson is relatively unlikely.  However, given the quality of the business, I would expect Clarkson to see its P/E ratio increased over time, particularly if the dividend pay-out ratio is also increased – something the company certainly has the scope to do.

Valuing the business using the free cash flow to the firm model, I use of WACC of 12.5%, a 7yr cash from operations growth rate of 6.2%pa and a terminal growth rate of 2%.  This gives me a valuation for the operations of £344m.  Adding-back net cash of £61.7m (ie, after the deduction of year-end bonus payables) and deducting the tiny pension liability, I get to an equity valuation of £405m, which is equivalent to 2152p per share, some 73% above the current share price!  In fact, the valuation looks so good that the current market capitalisation of £233m is fully-covered by the £61m cash balance and the forecast discounted cash flow for the next seven years (£175m).  Any earnings thereafter is essentially free money.

The cash generation characteristics and the relatively low valuation mean that the company is interesting as a potential takeover target.  Given the 22.9% ownership by the employees and 17.1% by Belgian shipping firm Compagnie Maritime Belge, a hostile takeover is highly unlikely.  However, it could make sense for the employees to take the company private, either on their own using bank financing or in partnership with a private equity firm.  A bank loan of £275m would be enough (along with the cash on the balance sheet) to acquire Clarkson at a 35% premium to the current share price and provide the company £30m of cash for ongoing liquidity needs.  At an interest rate of 7.2% (3yr GBP swap rate of 2.2% plus a 500bps bank margin), this would have an interest cost of £18m, 2.1x covered by the EBITDA generated during FY10.  That the business generates sufficient cash to finance its purchase with debt alone shows just how cheap the shares are currently trading.  Charterhouse Capital Partners completed a similar deal in June 2009 when they acquired energy research firm Wood MacKenzie.  While not a direct comparable, Wood MacKenzie is a firm that relies upon human capital, is a leader in its particular field and highly cash generative.

In summary, I believe that Clarkson has an excellent business franchise, allowing it to earn high returns through capitalising on the knowledge and information that it receives via acting as a key intermediary within the shipping market.  This deep knowledge of the shipping industry allows it to secure better rates for its customers, making it a counterparty of choice for ship-owners and charterers alike.  The shipping industry is highly-cyclical, but this has had relatively little impact on Clarkson’s earnings, suggesting that its income depends more on volumes than it does on freight rates.  That is not to say that Clarkson doesn’t benefit/(suffer) from strong/(weak) shipping markets.  However, Clarkson is highly cash generative and I do not believe this is fully-factored-in to the current share price, which implies weak and volatile future profits, something that is not supported by the historical financials or the current outlook.  The free cash flow to the firm model implies a fair value some 73% above the current share price, building-in a huge margin-of-safety for shareholders.  The potential for an MBO or a large dividend increase are the key catalysts for the closure of this valuation gap.

Disclosure: No position (but this may soon change).

Taken from the company’s own website, ASOS plc describes itself as:

ASOS is a global online fashion and beauty retailer and offers over 50,000 branded and own label product lines across womenswear, menswear, footwear, accessories, jewellery and beauty with approximately 1,500 new product lines being introduced each week. Aimed at fashion forward 16-34 year olds globally, ASOS attracts over 13 million unique visitors a month and as at 31 March 2011 had 5.3 million registered users and 3.0 million active customers from 160 countries (defined as having shopped in the last 12 months).

The company has a phenomenal track record, having grown revenues and earnings rapidly over the past few years, as shown in the table below.

This has been converted into exceptional share price growth, as shown in the chart below.

However, the shares now trade at a price of 2,466p, giving the company a market capitalisation of £1.85bn.  This is equivalent to 96x FY11 adjusted diluted earnings per share and 67x FY12E earnings.  Now, clearly the company is on a roll and is likely to continue growing revenues and earnings over the next few years, but this doesn’t necessarily mean the shares are good value.  I’ve reverse-engineered a discount cash flow model in order to understand what level of growth is required to justify the current share price.  Ordinarily, investors make projections for the future cash flow that will be generated by a business and then discount these back in order to estimate the fair value of the share price.  I often like to conduct this process in reverse, beginning with the current share price and using a process of iteration (trial and error) to calculate the rate of cash flow growth that the market has “baked-in” to the share price.

Given the rapid growth of ASOS plc, I have used a three-phase growth model: a high growth phase for the first five years, a medium-growth phase for the second five years, followed by a slow-growth phase thereafter.  I also use a cost of equity capital (another name for “target return”) of 10%, which I would view as relatively aggressive for such a young company.  My findings are as follows: in order to justify the current market capitalisation the company will need to earn free cash flow of £20m in FY12, grow FCF at 35% per annum for the following five years, then  at 18% per annum for the next five years, and finally at 5% per annum for each year thereafter.  Critically, this first assumption relies on the £26m capex spend in FY11 to genuinely be a one-off (ASOS plc separately reported £15.1m of capex for a new distribution centre).  Although these rates of growth are certainly possible, companies that manage to achieve them are relatively few and far between.  In addition, the small amount of fixed assets employed in ASOS’s business (only £25m) versus the company’s market capitalisation (£1.85bn) means that potential returns are extremely high for new entrants with deep pockets.  With such value-creation, it’s very hard not to see many new competitors entering the online retail business over the next few years.

The company’s own forecast is to grow revenue to £1bn by FY15, which would represent 31% per annum growth.  Therefore, the company also has to exceed its own targets in the near-term simply to justify the current share price.  My view is that ASOS plc is a great business and will likely grow revenues and earnings for many years to come.  However, at the current share price, the rates of growth required to deliver satisfactory returns to investors are simply too high and provide too great a probability of a downside surprise.  ASOS shares are priced-for-perfection and any less than this will likely see a significant de-rating of the shares.  Therefore, I reckon investors should avoid ASOS plc.

Disclosure: No position.

Related articles

• ASOS staff toast their success with early finishes and a free bar (telegraph.co.uk)
• International growth drives Asos (bbc.co.uk)
• Asos shares jump after fashion site predicts strong profits (telegraph.co.uk)
• Jennifer Lawrence Covers ASOS Magazine (shoppingblog.com)