Update: Euromoney Institutional Investor – 55% Undervalued

Posted on 28/07/2011

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Earlier this year I reviewed the UK-listed financial media group Euromoney Institutional Investor plc (report here), concluding that:

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.
The result is that net profit is forecast to increase from £58.6m in FY10 to £90.2m in FY10, with EPS increasing from 49.5p to 64.7p over the same period, a CAGR of 5.5% per annum, a slightly higher rate than the 4.2% between FY06 to FY10.  The build-up of cash on the balance sheet (£485m by FY15) means that returns fall dramatically as the balance sheet grows, with return on equity declining from 33.8% in FY10 to 17.2% in FY15.

In summary, I’m still concerned that ERM’s hard-copy publications could come under threat from the internet, the possible volatility of the share price, and the lack of takeover potential given the DMGT stake; however, trading has been strong since I reviewed the company six months ago, the valuation has become more attractive, and management have put the balance-sheet to work in order to grow the business and make for a more efficient capital structure.  Given these latter factors, and the significant undervaluation using the FCFF model, I’m quite tempted to add some shares to my portfolio.  However, to do that, first I need to decide whether or not to sell some existing holdings.

Disclosure: No position.
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Posted in: Investment Ideas