Billabonged Part 2 - TPG offer in early 2012 seemed right on the money!

Been continuing my series on Billabong in conjunction with my CFA Level 2 Equity revision.

The next part of Equity valuation is all about Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE). These values refer to the amount of cash available to all capital holders (FCFF) or just to equity holders (FCFE...with Debt Repayments and increases removed)
The formulas are as follows

FCFF = Cash flow from operations + (Interest expense*(1- Effective tax rate)) - Cash Flow from Investments

FCFE = FCFF + Debt increases - Debt repayments

Once you have FCFE, you can then use a DCF model to find the intrinsic value of equity and then divide by the number of shares on issue to get a value per share.

the DCF model used : Price = FCFE*(1*SustainableGrowthRatio)/(Rate of return - SustainableGrowthRatio)

Sustainable growth ration = ROE*(1- DividendPayoutratio)

So using all these formula's brings us to the following FCFE over the years for Billabong

2012           2011         2010         2009        2008        2007
85 million  64 million  13 million  32 million   197 million  196 million

Again 2009 was the year when people should have got out. A really massive drop in FCFE


Looking at the SustainableGrowthRatios is also reflective

2012           2011           2010        2009        2008          2007

-26%          3.74%       4.53%       4.55%      7.95%         8.36%

Rate of returns (Using CAPM, equity risk premium calculated August 2012 earlier on Blog, 1 year average of monthly 10 year Commbonds yields for riskfree rate and Beta calculated using moving monthly returns over 5 years, and then adjusted)

2012          2011             2010        2009       2008        2007
15%           12.65%        10.75%    13.06%   13.7%      14%

All up leads to the following intrinsic share prices

2012         2011             2010         2009       2008         2009
$0.49         $2.99           $0.86        $1.79      $17.97     $18.25

All these are based on the beginning of the next financial year...i.e in July 2012, the intrinsic price based on the FCFE was $0.49. The TPG offer was made in Feb 2012, when the intrinsic value was still at $3. They offered $3.30 which was a nice 10% premium. A lot of investors, I'm sure would have been hoping for that offer to be accepted, especially now as the share price is at 0.477. Actually might be worth a buy now as it is trading at a 2.7% discount :-)

Proves a couple of things
1. Private Equity are using FCFE for valuation
2. Good idea to watch these values over the years.
Note: Not a recommendation to invest/not invest in Billabong. Please see your financial advisor etc.

Market Risk Premium of ASX in April 2013 : 3.72%

Time for another update on the Market Risk Premium for the ASX.

Using my customary 2.5 years of individual returns for the ASX200, we have a market return (Capital Gain) of 3.27% p.a. Adding the average dividend yield over this time of 4.6%, means we have a market return of 7.87% (down from August 2012 by around 2%). Risk free rate (10 year Commonwealth Bond) average of 4.15% means our market risk premium = 7.87%-4.15% =3.72% (down from 5.13% in August).

Which makes sense I guess as interest rates have fallen, you would expect the cost of capital of equity to go down a little as well.

Valuing the ASX200 using the Gordon Growth Model - Seems undervalued

Still studying for my CFA Level 2 Exam (rapidly approaching in June) and came across that old friend, The Gordon Growth Model formula. What was new however, is using it to value indexes. So I decided to apply it to the ASX200.

As most of you know, the GGM formula is (Price today) = (Dividend Next Year)/((Rate of Return)-(Growth))

Using RBA figures, we have the average dividend yield over the last 2.5 years as being 4.6%. Applying that to the 1 April value of the ASX200 = 4931 we have a dividend today of 231.80. Assuming a growth rate of 3.25% (OECD forecast), that means next years dividend = 239.33.

Now to our rate of return. Using ASX200 daily returns since November 2010 (the usual 2.5 years), we have an average daily return of 0.0128%. Multiplied by the 256 trading days, we have an yearly return of 3.26%. Add on that dividend yield and we get 7.86% being our total market return.

10 year bond rate average over that same 2.5 yearly period gives us a risk free rate of 4.15%

Using CAPM (with the ASX200 Beta =1) we have a rate of return being 4.15+1* (7.86-4.15) =7.86%

Using g = 0.0325, therefore the ASX value should be 239.33/(7.86-0.0325) = 5183.

Therefore, with April's value of ASX200 being 4931, it appears by this definition that the index is undervalued by around 5%. Could also explain why the index has grown to 5100 today as people start to see the value.

Higher Learning

I'm amazed by the cutting of the HECS-HELP 10% discount announced by the Gillard Government. Talk about short sighted.

If you take away the discount, which according to the Gratton Institute report on Higher Education is only worth $40 million a year, you take away any incentive for people to pay university fees upfront. That means people will take on HELP debt and so add to the rapidly increasing stock pile of outstanding money (currently at $26.3 Billion).

The problem with this is that some of this debt is never re payed (approx $6.2 billion is estimated as doubtful debt) So that is a doubtful debt ratio of 23.6%.

Let's do a little exercise. If we assume $40 million represents the 10% discount, then 100% = $400 million. Thus $360 million would be the amount of money received by the government for upfront payments.

Lets assume that with the reduction of the discount, only 20% of people who currently pay up front, do so now. Therefore the amount that goes onto the Government coffers is $80 million, leaving $320 million going into the HECS debt pile. As only 77.4% of this is recovered, that gives up $224.48 million eventually going into the coffers, a loss of $75 million. And that doesn't even count the time value of money (the fact that $1 today is worth more than a dollar tomorrow).

Even if you use 17% as the doubtful debt ratio (Government's own figures), you end up with a loss of $54 million, still greater than the $40 million discount.

Only this government can claim this is a saving!

Billabonged....A story of declining Asset Quality, Earnings Queries and Off Balance Sheet Debt

Been running the ruler over the sad story of Billabong. What a disaster. A share price that tanked from the highs of 2007 ($16 odd) to it's current price of $0.53. When you look at the chart, there is an awful lot of value destruction.

So I decided to have a look at the fundamentals to see if there were any red flags a long the way.

And as far as I can see, there were four areas that would concern me.

1. Net Margin Decline
NPAT/Revenue went from 13.7% in 2007, to 13% (2008), to 9.13% (2009), to  9.75% (2010), to 6.9% (2011). Besides the brief uptick in 2010, it's been all downhill

2. Quality of Earnings
Accruals ratio went from 12.58% in 2008 to 19.78% in 2009. It then decreased to 2.78% in 2010, but jumped again in 2011 to 15% Clearly some inconsistancies in relation to cash management.

3. Asset Quality
Using my favourite ratio of ROA, we have it at 12% in 2007, but then a steady degredation to 11% (2008), 7% in 2009, 6.5% in 2010 to a miniscule 4.9% in 2011. Lots of money going into asset purchase, but no luck squeezing profit out of them.

4. Off Balance Sheet debt. When you include the non-cancelable operating leases to reported debt, you end up with a debt/equity ratio that is trending up from 0.66 (2007) to 0.87 (2008) to 0.73 (2009) to 0.59 (2010) and getting to 0.89 (2011)

So it definitely started to go pear shaped around 2009. The big red flag in my opinion was the increase in Accruals ratio in 2009 combined with the ROA reduction..Probably would have tried to get out then in my opinion.

Still, it's all in hindsight now isn't it.

Cock-a-hoop about Cochlear

Been running the ruler over Cochlear as it appears to have been shunned by investors. Not exactly sure why. But the share price has fallen though the floor in recent times.

Sure there have been some downside surprises on the earnings front, but a lot of the negativity comes from the product recall which is now in the rear view mirror!
Due to my CFA Exam 2 studies, I have been focusing on quality of earnings, specifically the Balance Sheet Accruals ratio. This gives you some insight into how much of the earnings are cash vs how much is accruals. Cash earnings are a lot more robust and sustainable than Accruals.

It involves calculating the change in the Net Operating assets over the years (also known as Aggregate Accruals) and then dividing that number by the Average Net operating assets over the years.

Using the annual reports, I have the following figures for Cochlear

2009-2010 - BS Accruals ratio = 15.5%
2010 - 2011 - BS Accruals ratio = 15%
2011 - 2012 - BS Accruals ratio = -22%!!!

Now a negative Accruals ratio is a good thing. It means that the Financial reporting is extremely conservative in regards to accruals (focusing more on cash earnings)

So there was an element of "taking out the trash" in the latest financial report. That is why I believe that earnings next year for Cochlear will probably surprise on the upside as the accruals ratio becomes positive.

 Note: This is not financial advise or a recommendation to invest, not invest in Cochlear. Please consult a financial advisor for all investment decisions.

Prediction for Reserve Bank - Hold rates at 3%

Once again, I think the Reserve will propose a "Wait and See" approach to the Australian Economy, especially with the whole Cyprus situation. This means the Australian Dollar will probably stay high for the foreseeable future.