Hargreaves Services Asset Valuation

Central Asia Metals

Central Asia Metals (CAM) – 09/09/15

Dividend yield – 6.08%

P/Exp FCF – 9.34

PT - £2.04

 
·      This is not conventional mining and therefore the cost structure and margins are much better than other miners.
·      Dividend policy offers healthy current and future yield. Investors are being paid adequately to hold.
·      Safe access to mining sector with the lowest cost producer in industry with very high FCF/dividend cover in coming years.
·      This actually becomes an income play plus a low risk exposure to future rising copper prices. 

Central Asia Metals (CAM) is a low cost copper producer and base metal exploration company with it's main operation in Kazakhstan and Mongolia. Their main operation in Kounrad, Kazakhstan is the business I am interested in. CAM are the sole owners and operators of a copper recovery plant, a facility that recovers copper from so-called 'waste dumps' that remain from the original Kounrad mine back from the 1930's. Long story short, they are very low cost producers of copper. 

CAM plan to produce 12,000 tonnes of copper in 2015 and at the current price p/t of copper is $5,390 will give around $64m of revenue in 2015 year-end, a 15% decrease yoy. They then plan to ramp up to 15,000 tonnes, and assuming this depressed copper price this gives us $80m annually of revenue from 2017 onwards.

Cost base

CAM has a fully absorbed cost of $1.65/lb in 2014 and $1.87 in 2015, with today’s copper price at $2.5. Increase in total cost is mainly due to increased depreciation charges, business development and hiring.

$.45c of this is production costs of cathodes, $.16c is mineral extraction tax and around $5m of costs is assumed to be salaries, taking into consideration the Directors are most probably paid in dollars. CAM’s fully absorbed cost of $1.87 implies the copper price has to decrease another 25% for the company to breakeven, excluding any future benefits from the local currency devaluation.

Management states that half of cash costs are in the local currency amounting to around $.32c/lb of costs that will be 70% of 2014 value. This reduces total cash cost to $.55c, a 26% decrease and gives a long run fully absorbed cost of $1.675/lb. This reduction in the cash cost will amount to an expected $5m in cash savings per year for CAM, increasing the dividend cover in the future.

An incident on site that halted production for a short period hurt results slightly in 2015H1. EBITDA margin was down to 53% and net margin in H12015 was down to 33% from 57%. Average sale price p/t was $5,936. A 16% decrease in average sale price resulted in 10% fall in revenue, although the halt in production also affected this.

CAM created $13.3m in cash in H12015. Extrapolating this figure prices CAM trading at 10x cash flow. The cash generated suggests CAM turned 44.3% of sales into cash flow. This cash flow is double the $6m of dividend payments agreed as 20% of revenue to shareholders providing some safety in ensuring investors are paid to hold this company.

How much does the Kounrad mine cost to maintain annually?

Capex is crucial. Operating cash needs to cover the dividend and any maintenance capex.

Estimated $6.5m maintenance capex needed for the Kounrad mine over 3 years is $2.16m per year. Total expansion costs for the mine is $35m of which $9.4m was paid in 2014, leaving $26m left over 3 years amounting to $8.6m. So we can assume around $10m plus growth capex for Copper Bay and any other external issues that arise to sum around $12m max capex per year.

Using a decreased operating margin of 40%, down from a 3-year average of 50%, on extrapolated revenue of $64m (12,000 tonnes at current copper prcies) implies OCF of $26m and FCF of $28.5 assuming D&A of $7m, capex of $14m and change in working cap at the historical average of 15% of revenue. This FCF amounts to around $.26c per share which gives a dividend cover of 1.76x. Summing PV of future FCF at discount rate of 12.5% gives an intrinsic value of $2.5, a 5.4% discount to current price. However, using the average operating margin of 50% gives a value of $3.06.

Return

CAM plan to return at least 20%, 25% in 2015, of the REVENUE from the Kounrad project to shareholders EVERY YEAR. This is a powerful insight on the incentives of management and their plan to continue returning value to shareholders. Estimated dividend yield is around 6.4% and therefore I would revalue CAM when the dividend yield gets revalued to the market average of around 4-4.5%.

H&T Group (HAT LN) - Asymmetric bet on a traditional business

'Money talks' was what my Dad always told me. This come to my mind when analysing the pawnbroking business due to the fact that cash-strapped individuals will always be willing to flog assets to raise short-term cash. Those willing to take advantage of the 'fire-sale' of assets could find opportunity. The demand for alternative credit, and in particular short term loans, is a business that has been around for centuries in one way or another and is likely to remain a stable cash generative business. This led me to H&G Group (HAT LN), one of a few main UK high street pawnbrokers remaining in a rapidly changing industry trading at reasonable valuations.

The Business

The group has four main businesses that are all somewhat integrated:

• Largest UK Pawn broking Business– secured short-term loans on jewellery and gold.
• Retail jewellery
• Third party cheque cashing
• Personal unsecured loans up to £1000

The pawn broking business is a very traditional business having been around since 1800’s. They take gold and jewellery as collateral for providing loans to cash strapped consumers. HAT have 191 high street stores around the UK and have started various other businesses that are synergetic with pawn broking such as selling unredeemed pledges through retail and gold purchasing.

Twenty-five percent of HAT’s total assets are receivables[1]; a majority of what mature within a year, twenty-five percent is inventory[2], gold and jewellery, used for retail and gold scrap upon unsuccessful redemptions. This gives the group a large amount of current assets, which are fairly liquid, and upon a fire sale would not take much of a haircut to the current market value. However, these assets are directly exposed to the price of gold, which has been in a downtrend for a few years and is one reason the company has been out of favour with investors.  

The group accept collateral of a notional value marginally higher than the loans they provide. They claim that this collateral is worth more than the loans provided even at gold prices near 5 year lows today. Therefore, even if customers do not repay the loans, HAT still make a profit as the collateral is of even higher value and can be sold through their retail business. Although the group redeem, on average, 80% of loans, “if the redemption rate decreases by 1%, i.e. the customer defaults on loan, the profits of H&T actually increase by £90,000”[3] at year-end 2014 pledge book values.

The business has suffered in the last 5 years due to a depreciating gold price and new strict regulation on payday loans. New UK regulation in 2013 capping interest on short term unsecured loans led lots of competitors to close down stores and investors dumping shares in companies relating to the business. Price of HAT fell from around £3.5 in 2012 to £1.5 even though personal loans only accounted for 3.9% of gross profit last year. The price is trading below NAVPS of £2.47 and seems to offer a low risk opportunity on any future growth of the business. However, the high margin business of payday loans is over and management is adopting a new business strategy.

Change of Business Strategy

Below shows the change in revenue composition and business mix in the last 8 years. This company has changed its strategy due to new regulation, the increased use of the internet for commodity linked loans and services and more importantly to reduce exposure to gold prices. They have introduced retail in 2008 to diversify their revenue stream and this has proved a success growing to around 30% of total revenue today.

They have reduced net debt considerably with D/E decreasing from over 40% in 2008 to around 19.5% today. Management claimed in 2014 that they’re concentrating on ‘developing new profitable products in the retail shops’ to boost revenue. HAT has rebranded their retail business and retail sales have a CAGR of 9.5% over the last 5 years and grew 25% last year.

The market is still partially valuing an old business with no potential growth. These future earnings streams do not have to be large for this company to outperform the current implied growth rates by the market. Not much capex is required to roll out the new business plan. They mainly lease their high street stores and space so just branding and marketing the retail business is necessary expenditure in the next 2 years. 

Management and Financials

CEO is ex RAF – he pledged to decrease net debt by 50% in 2013, delivered 54% and then reduced it in 2015H1 further by 34%. Seems very regimented in cost control, which is a key factor for changing business mix efficiently.

Margins are depressed and far below their 5-year average of 15% and 10% for operating and net income margin respectively. Today they are trading at 7% and 5% today due to the natural low margins of a more retail based business. ROE, ROA and ROC have all decreased as the business mix shifts more to retail and therefore future growth is now determined by sales growth and asset efficiency. 

The balance sheet is strong. They have halved net debt in 2 years to a D/E ratio of 19%, interest coverage ratio is sufficient at 12x and the company is £16m drawn on a £50m debt facility at 125bps above LIBOR. HAT has compounded book value at 18.56% a year over the last 10 years showing how prudent management are at managing the balance sheet and creating value. The Altman-Z score – a measure of the likelihood of bankruptcy within 2 years - of HAT is 4.21 is considered far from in distress (anything above 2.6 is considered safe).

FCF is very high relative to comparables and has been positive and increasing since 2011 even though the industry has been struggling and business mix changing. The FCF yield is currently around 16% and has been consistently above 10% for the last 10 years.

Risks

The main risk of this business is the dynamics of the business itself, the supply and demand of alternative credit. This is somewhat cyclical although the competitive landscape of the pawnbroking business ensures that when demand returns, HAT are in the position to gain market share.  The price of gold has proven to have little risk to the underlying performance of HAT as they do not lend too much at such high prices. An external risk is the use of Internet taking the service away that pawnbroking retail shops provide although H&T and cash converters are still around dominating the high street pawn broking market today.

Catalysts/Unlocking of value

The market is pricing a company in a dying industry with virtually no future growth. The gold price is at a 5-year low and HAT is still showing a healthy FCF yield and profit. Potential catalysts come mainly from two sources, growth in revenue from the retail segment or an increase in the underlying gold price. Price will follow as earnings grow upon potential:

• Improvement in the dynamics of the core pawnbroking business
• Increase in gold price
• Success of new retail revenue stream

Valuation

Rearranging P/B = (ROE – g) / (re – g) from the current P/B ratio of 0.8 and using the new lower 5% ROE shows the markets implied earnings growth rate of 1.4%. The company consistently retains earnings and looks to reinvest in the company. The 5-year average dividend pay-out ratio is 16.75% and therefore with the fundamental growth rate in earnings g = b*roe, using HAT’s new lower ROE of around 5% gives an average fundamental EPS growth rate of 4.16%.

The FCF/mkt cap has been consistently over 10% for the last 5 years. The business does not require the expenditure to purchase and roll out new stores it has in the past and therefore future capex will be lower. Capex per share was around 20p in 2012 and 2013 although last year, and after recent 2015H1 results, capex per share is now around 4p or 2% of revenue. OCF in 2015H1 was slightly lower than in the past due to increasing inventories (although management claim this stock will be cleared in H2) and therefore FCF was 24p per share. This prices HAT at around 8.25x FCF.

Discounting FCF at a 10% cost of equity gives a price target of around £2.4. Regardless of technical valuation I think this offers a low risk opportunity to benefit from any pick up in a traditional business, with liquid assets as protection, plus a cheap option on any future gold price appreciation.

This analysis was wrote on 20/08/15. 

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[1] All receivables on balance sheet are stated at nominal value as reduced by appropriate allowances for estimated irrecoverable amounts

[2] Inventories stored for re-sale are stated at the lower of cost and net realisable value which is valued at spot gold prices.
[3] Annual Report 2014