Clarkson plc: Cash Machine

Posted on 04/07/2011

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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).

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Posted in: Investment Ideas