Valuation – IPSA Plc

Independence: Yes, I do own IPS shares

Independent Power Southern Africa (IPSA) Plc is the first dual-listed share on both the AltX and the AIM (London’s AltX equivalent) and its business is “…to develop, own and manage power generation plants in southern Africa”.  Essentially, IPSA has two distinct businesses that it runs simultaneously that feed off each other: it develops power plants for sale or use in its second business, the operation and management of these plants.  Of these plants, IPSA specializes in making clean gas-fired power plants that are more environment friendly than the old “dirty” coal power plants of Eskom.

South Africa needs both of these businesses desperately due to its economic growth drawing on an increasingly shallow power grid of the useless Eskom legacy, Coega and its hefty future power needs, and the (quoted ad nausium) World Cup.

IPSA listed on the 19th of October this year at 560c, briefly went up to 755c on the 24th of the same month, and then came down to its present range of 590c to 600c.  So, basically it hasn’t moved listing…after issuing R31million shares at 562c and then a further R36million was raised by a share issue for cash to Stanlib at 605c per share.

This latter issue is above its present market price…interesting…

So, what we have here is a dual-listed company with solid blue chip shareholders who are subscribing for significant numbers of shares at a very small discount and, in the case of Stanlib, a premium to the market…this was one of the factors that put it on my radar as a possible buy.

IPSA is trading at 41.75 pence on the AIM and with a pound/ZAR exchange rate of 1:13.73, that makes it’s South African rand price of the AIM listed shares 573c (=13.73×41.75).  When I asked the CEO of IPSA, (the impressive) Mr Peter Earl, about this arbitrage anomaly his explanation was the following: “…there is little trading in the UK (i.e on the AIM) since most of the shares are firmly held by blue chip institutions and few (UK) private shareholders know anything about power in southern Africa.  That is the domain of people like Moore Capital, Fidelity and Tudor Capital who are among our more high profile shareholders.”

This makes sense, as if some company were to list on the AltX that specialized in power in, say, Ukraine…then I would probably shy away from it, as I know nothing about that country!  Also, reading between the lines of Mr Earl's statement gives you a picture of a lot of blue chip interest in IPSA…interesting…

This aside, I was worried about IPSA’s exposure to adverse forex movements, namely the Rand/Dollar and Rand/Pound rates.  As it imports most of its equipment into South Africa for its power plants, this is a critical factor.  Earlier in the year the weakening of the rand hurt IPSA profits, but, Mr Earl assures me, that the recent strengthening in the rand has neutralized this effect.  Of course, once all the parts are here and the plants are up and running, these are projects that are ZAR in nature and the exchange rates do not matter anymore.  Its really just the startup phase that is open to forex risk.

You’ll notice I haven’t gone into any number or forecasts or used any valuation models…this is because IPSA doesn’t have any numbers to work with yet.  AIM doesn’t allow its companies to provide forecasts (obviously to stop misleading the market) and the JSE released IPSA from having to make one, because of the conflict with the AIM rules.

This, of course, makes it hard to value IPSA and adds a layer of prediction risk that most shares don’t have.  Could it be for this reason that it is trading so low…?

My method of valuation of IPSA is based on a wide fundamental analysis of the sector and its management and a comparison with another power plant company with “..significantly the same management…”: namely, Rurelec Plc.

Firstly, Rurelec Plc has basically the same business as IPSA, except it is based in Latin America.  It even has (mostly) the same management, so serves as a good predictor of the future of IPSA (I.e. if they can do it there, why not be able to do it here?)  Looking at Rurelec’s financial statements you see that it is generating nice growing profits and shows a healthy balance sheet that weathered the startup years and the risks of importation etc.

So, it looks like the Rurelec Model works (which is a spin-off of the IPC Model)…just can it work in South Africa?  Well, without getting too technical about the different economies, I think Rurelec’s success is (at least) a definite positive sign for IPSA’s future.

Secondly, I could go into great depth about the power sector that Eskom dominates in South Africa…but this seems to be unnecessary.  Unnecessary, as I (skeptically) see this sector as run mainly by political forces that are subject to political decisions etc.  Also, IPSA works on a contract basis, thus, it either wins contracts or it doesn’t…which gives rise to 'contract risk'.  What counts in IPSA’s favor with tenders for contracts is the speed with which they can get a clean-fuel efficient power plant up and running.  This is because they don’t order the part (with a resulting lead of months or even years), but simply dismantle existing plants and reassemble them where they are needed.

So, ignoring the political risk of the power sector, I feel confident that IPSA will win significant tenders due to its speed and the depth of its management skills.


This leads to my third pillar of analysis: management.  I added up all of managements experience in the energy sector, and the IPSA team has a combine total of nearly 100 years of experience there, ranging from private equity, to Rurelec, to Russian projects…very impressive, indeed.  What I also like about management is that they had/have a collective 24.3% ownership of IPSA at the date of listing.  So, they have a strong financial interest in making IPSA work for us minorities.

There is one major aspect of IPSA that—until now—I have left out of this research paper: their projects.  IPSA looks at a 10 – 15 years project life with an Internal Rate of Return (IRR) of at least 20% pa. and writes up a backward and forward contract with the customer(s) and the supplier(s), locking in pricing.  Present projects are: Newcastle (that provides gas-fired steam to the Karbochem plant) that should begin producing profits early next year and is entirely equity funded; a Coega power plant or two that IPSA has signed a memorandum of understanding over; and Elitheni at East London that will use clean-coal technology to provide power to the Western Cape.

Other potential projects include, but are not limited to, a power plant in Durban and one for the Royal Swazi Sugar Corporation.

All of these projects have both 'contract risk' and 'political risk' attached to them, but I feel that these risks are nothing new to the experienced management team and IPSA should work in the long-run.

Of course, once IPSA is past the startup phase, it is going to be very cash-generative, should move into profits very quickly, thus it could become a significant dividend play.  This was conceded to me by Mr Earl in his email wherein he stated that “…we aim to get to first dividend as quickly as possible…”.

It all sounds very good to me; risky, no doubt, but with a potentially large upside.

Overall–although IPSA does have significant risks– the fact that lots of local and foreign blue chip investors are putting their money into it, the high potential power sector that it’s in, and its strong management team makes IPSA a buy.

Kind regards,

Keith McLachlan

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Valuation: ISA Holdings Ltd

Independence: No, I don’t own ISA shares

ISA Holdings Ltd is an internet security architecture firm who supplies design, integration, support, and a management for security solutions for a broad range of clients.  Their products range from firewalls, antivirus, intrusion protection, to encryption.  Their services range from consulting, management, to educational services.

As most have probably picked up, I am sceptical when it comes to IT and resource firms, because the formers products and services can become obsolete overnight, and the latter has little or no competitive advantage when its comes to selling its products.  Despite this preconception, ISA has a Dividend Yield of 10.34%, a PE of 9.4, and was a reverse listing into the old Y3K Group Ltd.  All these aspects attracted me to the share originally.

A little history on ISA reveals that it was a reverse listing into the old cash shell that was Y3K Group Ltd.  From there it discontinued Y3K’s business and began releasing strong results.  Most recently they have concluded a BEE deal, which basically saw it raise its BEE shareholding to an effective 35.234%.  This was achieved by issuing 62,592,593 shares at an average price of 35.234c per share.  This price is the weighted average of trade of ISA shares between 15 March and 2 May, less a discount of 19.18%!  That quite a large discount and the directors justify it by saying—besides the usual banter about their improved BEE status—that the BEE partners “…have extensive experience and knowledge of the ICT market and will bring both operational and strategic synergies to the group.”  Well, I’m not sure a 20% discount can be outweighed by only that and in my opinion is a bit excessive and shows a lack of creativity on managements part.  Why not issue convertible debentures and not dilute existing shareholders earnings…?  Still, ISA is a very small company with a market cap of only R111,703,703, and maybe they didn’t have the upper hand in the negotiations.  Unfortunately, a discount this big does not look good in my eyes and counts against the shares appeal.

I would have thought that ISA would have had a very good bargaining position, as its results have been spectacular.  2007 interim EPS increased about 35% to 2.74 from 2006’s 2.03.  Its year ended 2006 February EPS increased 49,35% from 2005’s 3.85 to 5.75.  Also, DPS has increased from 2c per share at the end of February 2005, to a 4c DPS at the end of February 2006, to a 2c DPS at the end of August 2006.  The 2c DPS is also an interim dividend, so a final dividend may well add to it.

All of these numbers are quite incredible, but has the share price factored them in?

Well, it has a 12 month high of 62c and its currently trading at 57c, thus its verging on uncharted ground.  But, its PE is only 9.4 and its DY is an incredible 10.34%!

A comparable share would be Datapro (DTP): it may not provide the same services and products (as it is into broadband), but it is also listed on the AltX and, being an IT company, it is also exposed to similar risks to ISA.  Datapro, though, has an extensive marketing campaign that not only makes the public aware of its products, but also—I suspect—supports its high PE ratio of 43.5!  If ISA were to be valued on the same basis as DTP it should be worth 281c (=43.5PE x 6.46EPS)!  Besides, ISA actually pays dividends, while DTP doesn’t.

Let’s say ISA has a beta of 1.5 (Profiles Handbook gives it a Beta of -4.74, but this is illusionary, as it includes Y3K’s influence), as it is a bit more risky than the market and thus more volatile than it.  Let’s also assume that the Dividend Cover remains at around 1.5 and that growth in EPS continues at a more conservative 30% and not last years 49.35%.  Also, the repo rate is currently 8.5% and, let’s assume, the market premium is around 10%.

Thus, the Cost of Equity of ISA is 25% (=8.5 + 1.5×10) per the Capital Asset Pricing Model and 38.74% (=(5.75*1.3/1.5)/57 + 30%) per the Dividend Growth Model.  Thus, lets make it the average of 31.87% (=(38.74+25)/2).

Using the Dividend Growth Model again and Cost of Equity of 31.87% and assuming a total dividend for this year of 5c, I can state that ISA’s fair value should be in the region of  267c (=5/(31.87%-30%))!  Another shocking result, but this time focusing on the dividends and not the earnings.

So, either all these calculations are wrong, or there is some hidden risk that makes ISA trade at a significant discount?

Well, for one, the directors hold a lot of the share—around 70%—and the liquidity is very bad.  It might actually be beneficial for them to release some of their shares into the open market, just to improve liquidity and boost the price…of course, an insider selling could have the opposite effect…

For an IT company, NAV is not really important, but I’ll state it here: ISA’s NAV is a respectable 21.09c at August 2006.  So its only trading at just over double its NAV.

Its D:E is also very low, sitting at 0.19, with a Quick and Current Ratio of 4.36.  So, ISA looks very safe to me with a set of very healthy ratios.

It gets a lot of its income off annuity contracts, which provides the strong cashflow platform from which it can declare future dividends.  It managed to generate just over R22million in the 6 months to August 2006.  Historically, it has also not had a net cash outflow since 2004.

All of this points to ISA being a good, solid company that is well run, closely held, and growing.  It appears to me to be a good investment, especially for those looking for dividend growth.

The liquidity makes ISA hard to judge, but the numbers point to a good buy.  My thoughts are that ISA is not going to shoot upwards (capital appreciation), but that it will continue to pay good growing dividends (dividend appreciation).  Based on the above discussion, I side-step my aversion to IT companies and give ISA Holdings Ltd a buy.

Kind regards,

Keith McLachlan

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Valuation: PSV Holdings Ltd

Independence: Yes, I own as many PSV shares as possible 

I was waiting for PSV’s interims to come out before reaching any official decision on this share.  They came out this morning and they did not disappoint. They did, though contain some unexpected positive surprises: not least of all PSV’s board has been buying back the companies shares at 62c!  Upon this matter the directors had the following to say: “…during the course of the period, the company repurchased 4,657million shares equivalent to 2,37% of the total issued share capital at an average price of 62c per share. … The Board’s view is that the company’s share price is intrinsically undervalued and it will continue to repurchase share in the open market at undervalued price levels.”  The interims placed the NAV of the share at 88.36c, while the current market price is only 71c!  A 24% discount.   Even the tangible NAV is around 36c.  That's only half the share price and is quite acceptable compared to other shares.

A company buying back shares is one of the most positive signs insiders can make (in my opinion) and R2,887,340 is quite a big sign for a small company.  Why is it a good sign, you may ask, well, view it as the company investing in itself.  Why would it do this, unless it thought it was a spectacular buy..?

But, looking closer I saw that on the 7th July 2006 Mr Dreisenstock (the FD) sold R276,000 worth of PSV shares at 69c.  This contradicts with the repurchasing of shares, so I questioned Mr Da Silva (the CEO) directly about the matter.  His response was that the all directors had significant financial interests in PSV that tied up a lot of their wealth.  Because of this, as and when it was needed, the directors would release small amount of their holdings into the market.  With the interest rates going up I guess even FD's need extra cash and, overall, it is a reasonable answer given the history of PSV.

Well, that's the cue to get into the history of PSV.

Mr Da Silva was one of the original founders of PSV, which was later sold to Set Point Holdings Ltd (Sethold).  But, fairly recently, PSV was repurchased by way of a management buy-out and taken off the market.  With the construction boom presently happening, it was the perfect time for PSV to be brought back to the market in order to raise capital and grow.

So, PSV listed via a reverse listing (I love reverse listings, but I’ll explain this later) into the cash-shell (i.e. not operating anymore as a company) Elixir.  Elixir issued sufficient shares for PSV such that PSV’s shareholders controlled Elixir.  It then renamed it PSV, issued shares for cash in a private placement at 80c each (raising R44million from this), and transferred its listing to the AltX.  From there the share has only gone down.

I love reverse listings, because the market often either undervalues them or just plain ignores them and really undervalues them.  My theory concerning this behavior is simple: most investors do not understand reverse listings.  These investors, when looking at PSV, see historic losses and negative NAVs, etc…and they don’t realize that it has nothing to do with the present company.  All the historic losses and negative PE and NAV is from old Elixir.  When PSV reverse listed into Elixir is wiped the slate clean.  Even keeping the historic AFS’s there is just a legal technicality, as fundamentals of the company is entirely different and entirely separate from that of the cash-shell it chose to reverse list into.

Now, most of the big institutional investors are intelligent enough to know this, but they often don’t invest in small caps.  (Hence, giving people like us opportunity for great investment profits.)  Thus, PSV, a small cap reverse listing, has been completely ignored by the market since listing.

But, enough of this philosophy, what does PSV do?

PSV calls itself a “fluid control specialist”, and this term is another reason why I think the market has ignored it.  Those that bothered to look at it, were simply put off by the fact they didn’t understand what PSV did.  I took the time to investigate and I came up with the following explanation.

PSV has a number of synergetic segments that all revolve around either engineering, servicing, or selling products related to fluids and fluid control.  They also have a segment that produces pumps…which in turn control fluids.  All of these products and services come together to give a comprehensive offering that derives income from the mining, petrochemical, and waste sectors of South Africa.  One of the more interesting things they do is keep water out of mines.  This is essentially an annuity based stream of revenue for PSV, as whether or not the mine is actually being used is irrelevant, as the mining companies have to keep water from flooding them.  Another interesting project that PSV is part of is fixing up the moth-balled powerplants of Eskom.

Upon listing PSV acquired Colvic Petroleum Products, which is a company that focuses on the manufacturing, supply, installation and maintenance of fuel handling systems at service station forecourts and fuel depots. Colvic also provides consulting and project management services to its customers, which include Sasol, Engen, Total and Shell.

Once again, notice the “fluid control” aspect: providing very interesting synergies between all these skill-dependant niche engineering segments of PSV.

What I really like about PSV is its customer base and its age: it has been operating for 18 year and in that time has secured a solid reputation with loyal customers providing it with contract annuity income.

So, as far as I can see, the fundamentals of PSV are hinged on two factors: industrial demand for its products and services and infrastructure spending that will demand its niche engineering skills.  Add to this that PSV has significant operations in SA's neighbouring countries and, thus, a weakening rand boosts its profits.

PSV’s forecasts predicted a EPS in the region of 15.2c for the year ended 28 February 2007.  This perked my interest, as the share has been trading between 65c and 70c, putting it on a PE ratio of 4.27 and 4.6 (=65/15.2 & 70/15.2)!  For a company with the prospects PSV has, this single fact is enough to make it a “condor”! (“Condor” is golf term for a hole-in-one on a par five..i.e. never happens.)

I wanted to wait until the interims came out before putting forward my official opinion, and I am duly impressed.  EPS for the 6 months to 31 August 2006 show EPS of 4.21.  But, the EPS of 4.21c was negatively affected by an accounting technicality and should really be sitting at 5.13c.  PSV has a cyclical year with most of the profits coming through in the second year, thus the Board feels very confident about achieving the forecast EPS.

Still, assuming they are not cyclical and this level of profit continues for the rest of the year, the EPS for the year ended February 2007 would be 8.42c (=71c/(4.21cx2)).  That puts it at a forward PE of 8.43 (=71/8.42)!  Wearne and Esor are trading at PE’s over 20…so why not PSV?  It’s even got more diversity in its product range than these two companies…and an arguably stronger niche from which to operate.

This diversity did help in the interims with the petrochemical segment falling 15% below forecast and the engineering segment over-shooting its forecast to offset the thinner petrochemical profits.

Now, ignoring the accounting technicality and assuming that the profits only double to year end it would be presently trading at a 6 month forward PE of 6.9 (=71c/(5.13×2)).

Say PSV is valued at PE of 15 and it doesn’t meet its forecast EPS, but only manages a 10c per share EPS for the 2007 year.  That makes its 6 month price 150c! (=10-x15)

These numbers coming through is the reasons I call this share a “condor”.

PSV concluded a BEE deal whereby the directors sold 30,000,000 shares off-market to a BEE partner giving them a 15% interest in the business.  With all the BEE deals going on PSV’s is only one I’ve ever heard of that was concluded at a premium to the market price!   Bakweneng (the BEE partner) bought the shares at 90c each!  This says something of PSV's value.

Furthermore, perusing the prospectus, I see that the directors have each committed to subscribe for a whole lot more of PSV shares at 100c each!

Here is a company that is buying back its own shares, selling them off-market at a 27% premium (=19/71) on market price to BEE partners, insiders options at 41% (=29/71) above market price…and with EPS looking healthy.  But, what do the ratio’s look like?

Well, PSV is very healthy: D:E is only 0.06 and its current ratio is 1.69.  So, its basically debt free with no chance of liquidity problems.  It’s Gross and Net Profit Margins are around 15% and 7.9% respectively.  Compare this to Howden’s (PSV’s nearest competitor with a PE of 16.4) Net Profit Margin of negative 0.58 and positive 5.14 for the last to reporting periods.

My fair value for the share right now, is the following:

The interim EPS of 5.13 (ignore accounting technicalities for now), doubled up to make the 2007 EPS of 10.26 (=5.13×2).  Now if Howden’s PE is presently 16.4 and its 2005 closing PE was 12.11, then let’s say that PSV’s PE should be around 12 to 10.  Let’s make it 10, to be conservative.  Using a discount rate of 10% the present day PE ratio should then be 9.5 (=.95discount factor x 10).  Thus, the price is should be trading at today should be around 97c (=10.26×9.5) using the PE Model.

This, of course, is ignoring the fact that PSV should make more profits in the second half of the year than the first half and that it is in a growth sector (construction and engineering).  Let's not forget the repurchasing of shares and BEE deal premium…

Thus, given the circumstances, I have to make PSV a strong buy.

Kind regards,

Keith McLachlan

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Valuation – Mercantile Bank Ltd

Independence: Yes, I do own MTL shares

Mercantile Ltd is a bank and an investment holding company with interests the ranging from domestic and international banking to financial services to both retail and corporate clients.  The weight of their profits flow from retail banking (110%) and alliance banking and other loans (34%), while their support services are running at a loss (-54% contribution).

With interest rates rising in the economy at the moment, any prudent investor should ask themselves whether investing in the banking sector now would be a good idea.  Mercantile is especially exposed to the rising repo rate, as its loan book mostly consists of retail clients (i.e. the general public).  Retail clients often begin to default in larger quantities as their interest payments move up.  Corporate clients, although yielding a lower interest margin (hence lower profits on the loans), are safer to lend to than retail clients.

Although in the short term the market can be fairly random in its movements, in the long term fundamentals always beat technical movements.  Hence I invest long-term.  Despite this I am hesitant when it comes to MTL as, since the interest rates moving up, Mercantile’s share price has dropped from a high of 45c on 12 January 2006 to the present day price of around 27c.  That’s a 40% drop!  The market has obviously factored in the rising rates causing Mercantile higher bad debts and lower profits…but will they be 40% lower?  Could Mercantile actually both withstand the rising rates and grow its earnings?

The SA Repo Rate (the rate at which the SA Reserve Bank lends to the banks, who in turn slap their interest margins on it and lend to the economy) has moved up 150 basis points (1,5 % points) since 8 June 2006.  That makes for 21% increase (=1.5/7).  So if the repo rate has moved up some 21%, why has Mercantile fallen a full 40%?  It could be the structure of the loan book coming into play, or just emotive sell-off of anything that looks like a bank.

Some history on Mercantile shows that it hit on hard times up until 2005, where it showed its first profit in more than five years.  Its majority shareholder (with 91.75% held), Portuguese state-owned Caixa Geral de Depositos, bailed it out through underwriting loans and rights issues and so forth.  The rescue attempt worked, as the cash flush Mercantile began to write back bad debts and recover its bottom line.  Most interestingly is that, while its EPS has barely moved from June 2005’s 1.09 to June 2006’s 1.10…the Cash Generated per Share (CGpS is a very important ratio as an indication of the health of a company and its ability to produce cold-hard cash) has changed significantly.  For the six months ended June 2005 CGpS was 4.9c, while CGpS for the six months ended June 2006 was all the way up to16.52c!  If the profits were measured on a cash basis and not an accrual basis, then this would put Mercantile at a (cash) PE ratio of 1.63 (=27/16.52)!  Wow…this figure alone made me investigate the possibility that Mercantile has both significant come-back/growth potential (with that much cash, surely they can make profits) and that the market had significantly oversold it based only on the interest rate movements and Mercantiles bad history.

For those of you that don’t know financial accounting, profits are accounted for when earned and not when the actual cashflow occurs. I.e. when the good/service is sold and not when the payment is recieved.  But…think carefully now: if a profit is earned then a cashflow will arise simultaneously, or proceed it, or come sometime thereafter.  In time cashflows should exactly equal profits.  Now, if MTL’s EPS was only 1.1, but its CGpS was 16.52…that points to some serious profits coming further down the line.  Looking at it on a macro-scale, Mercantile’s Net Profit was R45,000,000 and its Cash Generated by Operations was R648,363,000.  A significant difference if I ever saw one.

I’ve decided not to use either the PE Model or the Dividend Growth Model for valuing Mercantile, but rather focus on the level of its cash and its ability to generate cash.  But, looking at its ratio’s and specs one finds quite a rosy picture.

Beta is nicely defensive with a base 0.92, while NAV (made up of mostly cash) is 15.20 at 30 June 2006.  Its interest margin (the margin at which it profits from loans it makes) is a consistent 0.04, as compared with, say, Standard Banks interest margin of 0.02.  So, it’s lending at a good premium to compensate for the higher risk of the retail client base.  It has good capital adequacy ratios and appears to be in a fairly safe position: Liquid Funds:Deposits ratio (i.e. if all of Mercantile’s deposits are withdrawn at once how short will Mercantile fall) is at 0.53 compared to ABSA’s 0.09!  Quite a difference.  So, per this ratio, if financial contagion where to happen, MTL are in a safer position than the big banks, as they simply have more liquid funds to cover shortfalls.

There are certain worrying factors about Mercantile, though, as in its June 2006 interims it state that “…projects evaluating the replacement of the group’s core retail banking systems and enhancements to alliance banking systems are well underway and should be concluded by year end…”  It sounds to me like legacy costs of a badly designed system that might hurt future earnings more than any rise in interest rates ever will.  Of course, the new system would be classified as an asset on the balance sheet and not an expense.  Only small yearly depreciation would flow through the income statement, thus not really harming precious EPS.  Also, Mercantile is so cash-flush that it can probably afford to pay for any upgrades or changes with cash and not debt, so it might absorb this change well and even be in a position to benefit greatly from it.

Another aspect that alerted me to Mercantiles potential was that Mr Brown, Mercantiles CEO, bought R2,800,000 worth of MTL on the 31 March 2006 at…40c!  There often is only one reason why a CEO would buy shares in his own company: he expects the share price to go and he wants to make money off that rise.  The share price has gone down since then…but perhaps there is something the insiders know that we don't…  Of course, there is the positive externality to minority shareholders that he now has a vested interest in making the company perform.  Even to a CEO of a listed company, R2,8million is quite a strong incentive.

Overall, I like Mercantile a lot: its cash-flush, generating more and more cash, its well entrenched  in one of SA’s more positive sectors, it looks like it will be able to weather rising interest rates fairly well with all that cash, and it has good ratios that indicate that the comeback is well underway.  I really like the fact that the CEO bought R2,8million of the share, and I like the fact that the market has hammered the share price down to where the Cash PE Ratio is only 1.63…and where I can snap it up as a bargain.  I feel that Mercantile is both undervalued at present and has good potential to make a nice recovery (given the support and financial interest of Caixa Geral de Depositos), hence, for those of you looking for exposure to the banking sector and willing to take a risk I recommend Mercantile as a good buy.

Kind regards,

Keith McLachlan

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Valuation – All Joy Foods Ltd

Independence: No, I do not own any ALJ shares

 All Joy’s business is the development, manufacture, and marketing of a range of tomato sauces, mayonnaise, salad creams, specialty sauces, and drinking chocolates as well as other condiments.  Its product range aims at both low-income and high-income brackets with offerings ranging from mass tomato sauce’s (low-income), to pasta sauces (high-income), and to chocolate sauces.  These ranges are under the labels of All Joy, Gourmet, Kiddies, Figure, Veri Peri, Before You Braai…among others.

What I like about All Joy is that it was formed by the food-entrepreneur Marci Pather in 1986.  He is still the present Chairman and CEO and appears to be actively involved in every aspect of the business.  He holds 7.15% of ALJ’s shares and, with the other major shareholders, 91.79% of ALJ is closely held.  This may detract from the liquidity of the share, but it also gives Mr Pather and his fellow directors strong incentive to make the business work.  A very good thing for minorities.

Mr Pather also seems to be a very capable in his manager and All Joy has shown a strong and speedy ability to adapt in a highly competitive sector.  Always a good thing for a small cap, especially one in the low margin heavy competition sector of food and consumables.

Off their very good-looking (but slightly out-of-date) website, Mr. Pather is quoted as saying “…that there is no reason why All Joy cannot continue growing at the same aggressive pace for at least the next five years. Correct strategic positioning in the supply chain and close monitoring of market demands are, he says, key factors that maintain All Joy's successes and drive the company's growth.”

He goes on to say that “All Joy's strategy is to strengthen its position strictly as a food processor, avoiding the temptation to enter farming and converting raw materials… Narrowing its focus on what it does best…”

Not very relevant to this valuation, but of interest, is the fact that All Joy (along with Beige) was one of the first listings on the AltX.  Perhaps serving as a demonstration their ability to change with the times…

Some history on All Joy shows a very healthy profit history leading up to their 2006 financial year where the joy just seems to have run out.  During this year All Joy had a failed merger with Retailer Brands, a failed acquisition of Ehlobo Foods that ended in court, an accounting error that overstated profits by R295,747 in 2005 and R711,276 in 2004, and it posted a loss of 4.67c per share for its 2006 financial year.

A very dark year indeed and the share price has shown the strain with a high of 121c on 10 November 2005 and a low of 35c on 27 September 2006.  It is presently “trading” at 41c: I say “trading” because the liquidity of ALJ is very bad.  Only 51512 shares were traded in the last week of around R20,000 in value.  This is scary for those investors that are not long-term or might need to liquidate quickly, as the spread is very large.  But, it may also present ALJ as a good buy due a heavy illiquidity discount that has been slapped on the share’s trading prices.

This illiquidity discount shows, as the TNAV is 37.6c (NAV is 39.5c), which is only 9% below 41c!  A lot of this TNAV comes from the revaluation of land and buildings, so it is fairly secure and will probably increase each year with property prices.

The question, though, is two-fold: can ALJ come back to profitability, and can ALJ actually grow in the long-term?

Mr Pather’s remarks above about the 5 year growth are interesting, but unless its growth in profits (not losses) I’m not interested.

I have tried to get in contact with Mr Pather, but to no avail, thus what follows is purely analytical.

D:E is 0.54, which is fairly high for a company that had a cash outflow of just over R4,000,000.  But, this is offset by the lack of interest and the current and quick ratios of 1.25 each.  So, it appears that, although ALJ might be highly levered, its liquidity is alright…if it can start generating cash, that is.  The problem is the Cashflow from Operations has been negative for the last two years…

Their gross revenues have been dented by the change in the accounting standards: in the old standards, revenues used to be shown at full value and discounts shown as an expense, whereas now All Joy has been forced to show revenues net of discounts.  This makes comparing their revenues to prior periods fairly useless and perhaps also understates their growth.

Directors haven’t really dealt in the share, with the latest dealings being in 2004 and, thus, providing no indication as to what the insiders think.  While it is a good sign that no insiders have sold their shares, it is also a bad sign that none of them have bought any.  It feels to me like they seem to think that All Joy will pull together, but they are not certain enough to put money on it.  But, that is just the overall feeling I get.

As ALJ’s EPS are negative, its cashflows are negative, and it doesn’t pay dividends the PE Model, the DCF Model, and the Dividend Growth Model are all not applicable to ALJ or they would just give illogical answers as to the share’s value.

So, I will use an adjusted NAV Model.  As ALJ could well experience as loss next year, let’s use TNAV and not just NAV to be safer.  With TNAV sitting at 37.6c we can adjust it the following ways:

February 2005 final HEPS 5.2c and closing PE was 12.88, thus assuming ALJ comes back into profitability with a basic EPS of around, say, 3c then it should be trading at 36c (=12×3).  This of course probably won’t happen, so let’s assume that the 2006 years loss was repeated of 4.67c per share.  This loss included the costs of the failed takeover and the failed acquisition, thus, lets remove them…oh, wait a second: 2006 HEPS’s is  negative 5.5.  HEPS should contain only the core activities of All Joy, so it should already have removed the “extra” expenses of the corporate activity.  This appears like the corporate activity actually added to earnings!  Strange.

So, assuming that EPS is repeated in the future loss should be absorbed into ALJ’s TNAV taking it down to 32.93c (=37.6-4.67).

This is far below its present market price, which—I suspect—is being supported by the comments in the 2006 AFS about “the benefits of producing new brands under various brands will be realized in the year ahead” And the breakdown of the 16 months showing how some were profitable and others weren’t.  A bit vague for my liking.

I feel very skeptical, though, and I would rather be safe that take a gamble on investing in a company facing loses in a low margin high competition environment.  Still, All Joy does have a very strong brand collection, obviously good and motivated management, and could well surprise me in the future.

Thus, although I cannot give ALJ a buy, I have decided to make it a hold (i.e. wait and see if the turnaround works).

Kind regards,

Keith McLachlan

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Valuation – Jasco Electronics Ltd

Independence: No, I don’t own JSC shares

 Jasco is the holding company of three different businesses that lie within the telecommunications, manufacturing, and security sectors.  Namely, Webb Industries, Telescience, Tasslelane (all telecoms), Multivid (security), and Special Cables (manufacturing).  What attracted me to Jasco is that a company with a market cap of only R190million is situated in at least two good growth sectors (telecoms and manufacturing) and has pays dividends (let alone has a dividend yield of 3.27%!).  When I looked closely I also noticed the very low PE ratio of 9.4.

Jasco’s telecoms segment constructs masts and towers and places and sells Jasco’s electronic goods and software for telecoms.  This sector is supposedly subject to 25% growth, but I suspect that this number is lit bit of a PR exercise, as Jasco’s telecoms segment only grew by 17% for the 6 months ended 31 August 2006.  Still, the sector presently has definitely gotten good growth potential. Manufacturing rose 30% in the same period, while security dropped a little.  Luckily security is the smallest segment making up only around 15% of revenue.

The telecoms segment is by far the biggest in terms of revenue with over 55% coming from it.  Thus, the future of this segment, in large way, determines the future of JSC.  I feel that this is a good point for Jasco.  It's telecoms segement focuses on providing solutions, products, and services to the access net works of both fixed line and wireless telecommunications network operators.  What is very good about this segment is that margins are increasing from last years operating margins of 12,8% to this years 13,7%.  But, this year the Mast and Towers division was excluded and its lover margin operations might have been the sole boost here.  I like the positioning of this fixed line and wireless segment a lot, as the Second National Operator being approved and the government infrastructure are going to all add to growth here.

The Manufacturing division gets most of its revenues from Special Cables, which manufactures and assembles wire harnesses and plastic moulded components for large domestic appliances, pool products, and niche automotive control units.  The problem is that this sounds very consumer dependent: i.e. cars and pool appliance are extremely interest rate elastic goods.  So future growth in this segment will probably be negatively effected by the present rate hikes.

Finally the security segment offers electronic security solutions as integrators of stand-alone and closed circuit sercurity television networks (CCTV), access control, pneumatic tube (whatever that is!), and alarm monitoring systems.  Pretty standard items, but, once again, a very small part of the larger Jasco.

Earlier in the year Jasco withdrew a cautionary announcement because it had terminated negotiation where it was attempting to acquire another “substantial” business that would have “almost doubled Jasco’s size” (which means that they were probably going to issue at least part of the purchase price in equity) and would have boosted Jasco’s BEE status.  (Jasco is already BEE empowered, though) They terminated the negotiations because they felt the acquisition was too risky for the amount of reward expected to be gotten, but the due diligence up till then cost them R1,4million in expenses.  Excluding the failed takeover expense of R1,4million the EPS growth would have been 43% for the 6 month ended 31 August 2006.  This is substantially above the 23,5% growth in EPS reported.  Management terminating a risky acquisition, I think, is a good sign, because it means that they are looking at real value when making acquisitions and not just making “vanity/ego” purchases.  Good for the minorities.

Looking at Jasco’s financials, we see a very healthy looking balance sheet with lots of cash (R13million) and little debt.  The D:E ratio has been decreased from a risky 0.88 in 2001 to a safer 0.39.  Long-term liabilities are negligible, which added to the interest cover of 56.39 gives a picture safety.

The income statement also looks good with an operating margin and a net profit margin growing from 6.9 and 4.54 to a 7.36 and 4.73 at 31 August 2006.  Return on Equity is also nicely up from 14.22 to 15.40.  The EPS and HEPS grew 23,5% and 23,2% to 12,1c and 8,5c respectively.

The JSC share is also sitting at PE ratio of 9.4 and a DY of 3.27%.  This makes the share look relatively cheap compared to blue chip Altron’s PE of 15.1 and DY of 2.74.  Still Altron has a market cap of R2,7billion, which makes it 14 times bigger than Jasco.

Altron’s dividends are expected to grow by about 13% next year, so assuming that Jasco’s grow at about the same from 9c to, say, 12c.  And it DY stay approximately the same.  It has a historic beta of 0.30 (per Profiles Handbook) and this gives it an approximate Cost of Equity of around 13% (=10% + 10%x0.3).  So, assuming the same growth rate as the most recent EPS we have a one year share price of…oops, we have a situation where the growth rate exceeds the Cost of Equity!  Thus the Dividend Model can't be used.  This is probably because of the lack of any significant debt that makes Jasco a relatively safe bet.

Using the PE Model and assuming a PE ratio of 10 you could forecast a one year share price of 314c (=26.17×1.2x10PE).  This would give you 12% return on a purchase of the present bid price of 280c.  But, and this I think is more probable, assume the PE ratio begins to approach Altron’s because of a future acquisition or two and reaches, say, 13 by next year.  Then the one year price would be 408c (=26.17×1.2x13PE).  A full 45,8% above 280c.

Now, ignore the R1,4million acquisition expense.  Say EPS next year don’t increase by as much as 40% (which this years EPS would have if the R1,4million expense was left out), but only by 30%…and the PE ratio creeps up (not to 13), but say 11.  Then the one year share price is 374c (=26.17×1.3×11), which makes 34% on 280c.

These are all ballpark assumptions, but they do give a range of prices to work with.  All of the returns ignore the stream of dividends Jasco is paying, which—of course—add to the appeal.  (It didn’t declare one at the interim 31 August 2006 date, as it’s company policy is only to declare one at year end.  So that's still to look forward to…)

All of this makes me like JSC a lot, but, before I say anything more, let me point out what I don’t like.

Its NAV: NAV is 157.3c, while TNAV is only 104,4.  That’s only two thirds of tangible’s…and points to a possible glut of goodwill in the balance sheet.  Of course all Jasco’s purchases and acquisitions (i.e. its three segments) are making good returns, so perhaps the excess of 33% over tangible assets paid was worth the price..?

Despite this, I like Jasco and I think it has good growth potential.  Its in a very good sector, Telecoms, with two other promising contributors to fall back on, it has lots of cash, little debt, a defensive beta, and good management.  Added to these fundamentals, it pays dividends and its probably going to make one or a couple of acquisitions in the near future that should, hopefully, boost growth.  So I will classify Jasco as a buy for those wanting to enter the telecom infrastructure sector and get exposure to manufacturing and security…oh…and dividends…

Kind regards,

Keith McLachlan


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Valuation – Wearne Ltd

Independence: No, I don’t own WEA shares

There is little doubt that a company that lists at 100c and within a year is trading at around 400c is a diamond, and Wearne is one of these.  The question is whether all the future growth has been factored in, how sustainable is the future growth, and whether it is worth investing in now?

Wearne is a ready mixed concrete and aggregate supplier with about 70% of its gross profit coming from its ready mix concrete segment.  The other 30% comes from the aggregates segment.  Wearne main customers include the construction industry at large, the housing and mining industries, and various government projects (now that they’re 16% BEE compliant).

Wearne has a rich history with 96 years of operations under its belt.  It is owned and managed by the Wearne family with the very likable John Wearne as the CEO.  I like the fact that it is family owned, because—despite the experience the family obviously has—they will also work hard to protect their financial interests, i.e. WEA.  This should benefit minorities in the long-run.  WEA was also the first construction listing on the AltX (before Esor and PSV) and has led the bounce in this sector.

So how are the financials and what sort of a forecast can be made?

Well, being in the construction industry and being a supplier of concrete to it, Wearne is perhaps in a bit of a volatile and competitive industry.  On the other hand they have a well established brand and a well run business.  The latter perhaps helped for them to beat their listing forecast EPS of 12.25c by 28% to achieve a 2006 EPS of 15.65c, but possible the main driver of the earnings growth was the increased retail price of their product that filtered through to higher margins.  This was demand driven due to the booming economy.  Wearne’s forecast 2007 EPS is 13.42, but more importantly it is forecast to be about 10% higher than the 2006 EPS.  This number will be used later.

Wearne recently bought  the business and moveable assets of W de Bruyn Sandwerke, which are stone crushing and ready mixed concrete plants strategically located in areas that cover the Free State, Guateng, North West and Limpopo provinces.  Wearne cited the reduction of reliance on third parties for materials and the increase in Wearnes share of business in Guateng as the main reasons for the purchase.  Sounds good, and should have a lot of synergy.  Furthermore, the pro-forma financial effects showed that the 2006 EPS would have grown by 39% and the 2006 NAV would have been boosted by 66%.  The NAV increase could well be because of goodwill with no real substance, but the boost to EPS should come through to the 2007 year very nicely.

So, if the purchase boosted EPS by 39% and the forecast showed a 10% growth in 2006 EPS, this leads me to estimate a good average between them of, say, 25% to be safe.  But, WEA has a very high PE ratio, which is typical of a high growth firm, but it is also not sustainable.  As growth runs out the PE ratio should come back down to earth.  WEA presently sits with a PE of 27.3, while PPC—a comparable share of another large cement company—sits with a PE of only 16.6.  16.6 is fairly high for a Blue Chip, but PPC has the same bright future that all SA construction firms share.

So, lets say that WEA’s PE ratio comes back down to PPC’s in the next two to three years, while earnings grow by 25% p.a.  That puts a one year price of 391c (=15.65×125%x20PE) and a two year price of 405c (=15.65×125%x125%x16.6PE).  This is assuming that the PE comes down to 20 at the end of 2007 and 16.6 at the end of 2008.  The closing price today is 400c.  If my calculations are correct, all future two years growth is already factored into the present share price.  But, I might be wrong, as my growth assumption is very susceptible to details, like interest rate hikes etc.

Say growth is actually 35%, which is very probable, then the two year price is should be 461c (=15.65×135%x135%x16.6) with a PE of 16.6.  This gives one a two year growth of 15.25%, or 7,625% per annum.  Still not very impressive.

But, say growth is actually 50%—as unlikely as this is—then a two year price should be 570c (=15.25×1.5×1.5×16.6) giving a return of 21% per annum.  Not bad, but very improbable.

There are a number of factors I’m leaving out—like the synergies of the purchase, government spending, the awarding of a couple of major contracts to Wearne—but overall, I cannot see how WEA can continue to rise as fast as it has in the recent past.  What often happens with such diamonds as Wearne, investors become overly optimistic and emotional.  They then proceed to bid the share price up far ahead of where is should be.  I think it should be around 300 or even 320c, but definitely not around 400c!

I think that this is a card house that is about to topple.  I'll rather wait until then to invest in a good company, than do so now at the risk that my forecasts are right.

I am definitely not saying that the underlying company is going to fold…no, WG Wearne is an excellent company and will continue to make profits till the cows come home.  What I am saying is that the share is overvalued and, at this price, offers very little small caps growth potential.  Thus, I am forced to go against what the entire market is saying and label WEA a sell.

Kind regards,

Keith McLachlan

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Valuation – Zaptronix Ltd

Independence: No, I don’t own ZPT shares

Zaptronix is a very complicated valuation indeed—the share price volatility of ZPT in the market agrees with me here—as it is a simultaneous come-back, reverse acquisition, tech-company, product and service refocus, and a year end change from April year end to August.  The come-back and reverse acquisition of DuO Solution Provider Ltd make its historic figures pretty much meaningless for forecasting future results.  The change in year-end adds an extra spin on these figures, as some results are for 16 months while others are for the usual 12.  And the come-back aspect just adds risks due to possible hidden downsides lurking just off the financials.

Where to begin…

Well, ZPT’s recent company focus—incorporating DuO’s services into it—sees it focusing on the risk management services of DuO through logistics and vehicle/fleet tracking through to the manufacture of electricity meters and the related services and software (MEMS and EMS).  If this sounds confusing to you then you are not the only one.  But the best picture I can get about what Zaptronix does (which is off their terrible website) is that they make and sell meters for reading and controlling flows (electricity) and the tracking of vehicles and provide related software and services.  The electricity meter systems (EMS) clicks nicely into the power crisis presently underway in South Africa due to Eskom’s bad management.  Eskom just happens to be one of Zaptronix’s customers and they, according to their outdated website, sell—for a commission—Eskom’s power and solutions.  DuO on the other hand tracks fleets….so where are the synergies?  I don’t really know, but Nel—the CEO—says that the synergy of the reverse acquisition is found in their in-house software development, which conducts monitoring, measuring, and controlling.  Monitoring, measuring, and controlling power use for the EMS and monitoring, measuring, and controlling fleet movements for DuO.

Put this way it doesn’t sound half bad, but let’s look at the financials and see if the numbers will confess any secrets.

The 6 months to February 2006 gave revenue of R10,056,000, while the 16 months to August 2005 gave revenues of R28,292,000.  Thus the 12 month revenue for August would be R21,219,000 (=28,292,000/16×12).  Divided by two it gives us a 6 month revenue of R10,609,500.  That means that revenue for the 6 months to February has declined a bit.  And HEPS for February are 0.06c as compared to the comparative for the 6 month period to August 2005 are 0.195c (=0.26c/16×12).  That’s a 225% decline, if I am correct in all my assumptions.  Management did not point this out, but rather issued a SENS stating how EPS and HEPS are going to be up by 240% to 260% and 290% to 310%.  This was comparing it to a previously unconsolidated financial statements that did not include DuO’s results.  The manner of the SENS and the wording I dislike and I get the suspicious feeling that Zaptronix directors are out to confuse, dumbfound, and misdirect shareholders as to what the results actually are.  Hence all the changes and the long explanations why the results aren’t that bad.

I don’t like it all.  One of the signs of a good small cap is the quality of the corporate communications that its directors feed out to the minority shareholders: bad/confusing/misleading info = bad management or hiding something, while good info = solid/realistic/nothing hide/honest management.  As the saying goes, “..a boat cannot sail without a captain…”, so how can a company be expected to make profits without good management?

Having said that, I do like the EMS system idea and its positioning.  It might make very good profits if Zaptronix can come right corporately.  EMS and fleet management combines the promise of the sectors of Digicor with that of a product that could take off spectacularly.  But Digicor is more structurally sound with its solid fundamentals and proven track record, while Zaptronix has zero cash, an overdraft of R429,000, and no track record.  The right product does not necessarily translate into profits: it does help to, but it is by no means a guarantee.

Zaptronix’s liquidity and solvency ratios gives a comforting picture with an interest cover of 3.96 and a quick and current ratio of 1.23.  D:E is sitting a little high at 0.50 for a company like this, but the interest cover ratio at least marginally displaces this worry.

Looking for what models to use all of them fall short for a number of reasons: ZPT doesn't pay dividends, earnings and PE are too volatile, and the present Zaptronix company is pretty much untested so historicals can't be used.  The most important reason why the models fall short, in my opinion, is because their implicit assumption is that the underlying data is accurate, which in this case might not be true, as historic data for ZPT is pretty much meaningless in forecasting its future.

Zaptronix recently concluded a BEE deal with Royal Bafokeng Group which saw them acquire a 30% holding in ZPT through shares issued at 16c.  Zaptronix is presently trading at around 10c today…so why the massive 60% premium paid by the Royal’s?  Premium for control maybe?  Just another ZPT mystery.  What makes it more of a mystery is that the numbers haven’t come through: NAV of only 1.88c at 28 February 2006.

This is because the Royal’s have gotten that 30% shareholding through various options that supposedly mean that Zaptronix shareholders’ interests won’t be diluted…but also means that Royal Bafokeng Group probably don’t have to pay a cent yet.  Draw your own conclusions here, but the rest of what I found when I researched this share has made me very bias: I don’t like it at all.

I like the products and ideas, but not enough for Zaptronix to be labelled anything except a sell.  I will add this much, that I would consider buying a small amount at, say, anything at or below 6c or so, but above that I don’t believe the return adequately compensates an investor for the amount of risk involved.

Kind regards,

Keith McLachlan

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Valuation – Pinnacle Holdings Ltd

Independence: No, I don’t own PNC shares

There are two types of companies that I don’t like: resource companies and IT companies.  The former I don’t like because they have no product competitive advantage in that one ounce/lump/pound of gold/iron/coal is the same another ounce/lump/pound of gold/iron/coal.  The latter I don’t like because the very environment in which they operate can change so fast that what was once an excellent lead product/service is now outdated and redundant.

Pinnacle calls itself a supplier of IT products and services, including computers, peripherals (fancy word for extra’s, like flash drives and webcams) and networking products, as well as value-added sales and support services and installation and financing schemes.  So after all the regular corporate sales talk, what Pinnacle really does is sell hardware, software, and IT services.  The hardware includes Intel and the software includes Microsoft, which is good, because it means that Pinnacle can sell all the hard work and innovation of these other businesses.

On a historical note, Pinnacle did weather the bursting of the IT bubble a bit better than its peers and it’s been through the rough years toughening up its management…the thing that concerns me about them is two fold: they are buying profits through acquisitions and they are in the IT sector.  But, we’ll look at that later.

Amabubesi, a BEE company, recently bought a 20% stake in PNC with various put options to sell it back in 2009 if Pinnacle did not perform (which PNC luckily just about have) and Pinnacle got a first right of refusal to buy back Amabubesi’s stake if they wish to sell it.

A very tentative deal if I ever saw one, but rather tentative than risky and, because Pinnacle services/tenders a couple of government institutions and blue chips, it does open a couple of doors to future profits…albeit at the cost of diluting present shareholders.

Pinnacle also issued seven million shares at 50c per share to T Tshivhase, an executive director, under a staff share purchase scheme that pushed the BEE status of PNC to the critical 30%.  Just perhaps the shares were given away a bit cheaply, seeing as the current share price is around 280c now…

Following from this insider trades are often a good indication of a company’s health, but PNC track record is truly confounding: 54 separate trades since 30 October 2002 with 32 being buys and 22 being sales.  Most companies have only a couple.  What does it mean?  Besides the fact that the directors themselves appear to disagree a lot on the value of PNC…well, I don’t actually know.  Perhaps it means that stock exchanges should require disclosure of reasons for buying and selling by insiders.

Pinnacles management have made a string of acquisitions in recent years by buying (with various combinations of cash and equity) the remainder of Pinnacle Micro Cape (Pty) Ltd, 40% of RentNet, and an effective extra 50% of Explix Technologies (Pty) Ltd from Hendev (Pty) Ltd and ITCM.  The results of these acquisitions have been to inject growth to net profit, but the question is whether this growth was once off due to clever purchases or will continue into the future.

Management are quoted as saying “…the acquisition of an additional 50% of Explix contributed approximately R107million (15%) revenue and organic growth R239 million (33%) to the 48% increase in group revenues to R1061 million…” for the year ended 30 June 2006.

So PNC really grew about 30%, which is not at all bad, but far from the 99% EPS growth one sees at first glance.

Looking at the financials the 2006 year shows a growth in EPS of 99% from 2005 and the DPS growing to 7c from 4c in 2005.  There was also a net cash inflow—always good—of about R103million, but R43million of it came from the share issue to its tentative BEE partner.

What I don’t like is the high gearing ratio of a D:E of 0.74 with a current ratio of 1.28.  But its interest cover is non-existent, as most of its debt appears to be non-interest bearing.  Still, it does have to pay back the capital sometime.  It also has a TNAV of only 78c.  The small TNAV, though, it typical of an IT company with a lot of its assets off the balance sheet and in its employees skills.  This higher level of debt with the added risk of being in the IT sector has given Pinnacle a 3 year historic beta of 4.47 (according to Profiles Stock Exchange Handbook: Jan – June 2006).

If the risk-free rate is around 9% and the JSE market risk premium is around 10% then PNC has a required rate of return or cost of equity, per the Capital Asset Pricing Model, of 53.7% (=9%+4.47×10%)!  As ridiculous as this may sound, it does point to the fact that PNC is a lot riskier than most people realise.

The market has given them a DY of 2.56% and a PE of 8.9, as compared to Mustek’s—another IT technology and hardware company of JSE—DY and PE of 6.25 and 21.7 respectively.  So either Mustek is paying too higher dividends or Pinnacle is overvalued…just a thought.

Using the Dividend Growth Model and assuming that Pinnacle’s organic growth of 33% continues into the 2007 year we can assume that DPS will be around 9c (I could say 10c, but I’m being prudent).

Thus the forecast 1 year price of PNC (using the ridiculous Cost of Equity of the CAPM above) should be around 43c (=9/(0.537-0.33))!  I don’t agree with this, but I’m using it to demonstrate why the PE Model is better suited to Pinnacle.

Its historic PE has grown from 1.78 at the end of June 2002 to the present day PE of around 8.9.  This shows growing investor confidence in the share.  Thus I feel it is reasonable to forecast a future PE of around 9.5 (once again being conservative).

If the 2006 EPS were 30.27 and organic growth sits at around 30%, then the forecast one year price can be expected to be around 374 (=9.5×1.3×30.27).  This gives a one year growth in share price of around 34%.

But, how safe and predictable is this growth and will it slow down, speed up, or remain?

The majority (around 70%) of Pinnacles revenues stems from what it labels as “infrastructure and support”, which I take to mean hardware and the services of installation and maintenance etc.  The support aspect of this revenue stream means that it is at least partly annuity based, which I like, the dynamic and volatile character of the hardware environment adds too much risk for my liking.

Despite the BEE credentials, recent impressive growth, dividends, and other alluring aspects, I cannot find any piece of conclusive evidence that the growth in Pinnacles earnings can be sustained over the long-term and the recent growth has been nothing more than mostly purchased and accounting related.  Either that, or with the PE ratio at an all time high, the growth has already been factored into the present share price.  Add to this the risky nature of the IT environment, and we arrive at the reason why I just cannot classify PNC a buy.  Going against what the market seems to be saying and looking at it objectively, I feel that Pinnacle is riskier than most investors realise and that the share—although not presently overvalued—does not offer any significant growth factors in the future to counter the risk.  Despite this, PNC is well-run and pays good dividends, so I also cannot label them a sell.  Through this process of discrimination I am forced to place them into a temporary “hold”.  I'd keep my eye on them for the present, but I wouldn't invest just yet.

Kind regards,

Keith McLachlan

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Valuation – Amecor Ltd

Independence: Yes, I do own AER shares.

Amalgamated Electronic Appliances Corporation Ltd, Amecor, is the end result of an extensive restructuring and listing change of the old Tisec Ltd which saw a number of significant new shares listed and a 1 for 10 share consolidation on the 29 August 2005.  Amecor is the holding company of FSK Electronics and Sabre Alarmnet, whose principal business consists of the design, manufacture, and supply of electronics equipment, technologies, and solutions to the security industry.

With a present price range of 180c and 190c, a market cap of around R141million, and a twelve month high and twelve month low of 150 and 190 respectively, Amecor falls well within my definition of a small cap.  In the year ended 31 March 2006 it also beat its forecast EPS and HEPS by between 15% to 25%.  This may not be as significant as it sounds, as companies often underestimate their forecast earnings so that when the results come out they have a bigger positive effect on the market.  Still, this may not be the case here.

Due to the recent restructuring and share consolidation Amecor’s recent results are basically incomparable to any historical figures, so the focus of this valuation will be upon the present balance sheet and management, present and future dividends, and the fundamentals of the sector.

The AER share’s biggest weakness is its relative illiquidity, with only an average of around R13000 worth of shares changing hands per week.  The management of the company tried to address the lack of liquidity by placing around 6,000,000 ordinary shares with six institutions, which seems to have worked relatively well.  But, the act means more than just that: the management of Amecor obviously factor in the share’s performance on the market into their decisions.  Whether or not they do this to benefit minority shareholders or because of other incentives is up for debate, but the positive externality is unquestionably there for the minorities.  This, in my opinion, is a very good thing.

The NAV of the share is 99.66c, while the TNAV is only 16.8c due to all the goodwill arising on acquisitions.  The balance sheet, though, is looking quite healthy with a surplus cash holding of just over R10million.  This helps give rise to a very good D:E ratio of 0.09, a current ratio of 5.93, and a quick ratio (current ratio with all unsold inventory taken out of assets) also of 5.93.  The interest cover is basically nonexistent, because of the lack of interest bearing debt that gives rise to the low D:E ratio.  Amecor also has a company policy of paying out dividends only at year end with a dividend cover of 3, thus lowering the cashflow needs and keeping sufficient profits back to boost future organic growth, but also returning a steady flow of cash back to its shareholders.  My assessment of managements ability to manage cashflow sensibly is backed up by the increase in cash and cash equivalents for the year ended 31 March 2006 of R8,8million.  Although a R55,8million inflow of this came from issuing of shares, a R10million was generated by operations.

Amecor’s appeal comes from its high operating and net profit margins of 53 and 40 respectively.  This means that a small increase in revenues will filter through to a substantial increase in after tax profits and EPS.  This, due to the company policy of a 3 times dividend cover, will also find its way into the back pocket of the investor.

In South Africa the security market has grown significantly in the past couple of years due to a number of factors, not least of all the increase in the crime rate, the increase in the average citizens awareness of crime, and the growth in security solutions and technologies.  This last factor, of course, means that competition is intensifying, but as evidenced by Amecor’s healthy margins, they seem to be able to handle the competition.  A good aspect of the security retailing sector, from the perspective of Amecor, is that security is an inelastic good.  This means that consumers need security at home, in their car, at work and all over the place and an increase in price does not dampen this need by more than the increase in overall revenue.  An added bonus here is that a rise in the interest rate that eats away consumer’s disposable income will have little effect on the demand for Amecor’s profits due to their inelastic nature and it will have little effects on Amecor’s interest expense due to Amecor’s low gearing ratio.  The inelasticity of its product is the real reason for the high profit margins…but interestingly does not appear to translate well into the PE ratio of Amecor, which is sitting at a modest 9,5.

The low PE ratio could be evidence of the premium investors demand for such an illiquid share, but probably is also the risk premium for investing in such an untested company as the restructured Amecor is.

If Amecor’s profits grow by a modest 20% for the year ended 31 March 2007 then an HEPS of 24.12 (=20.10×1.2).  With a dividend cover of 3, this means a dividend of 8cps (=24.12/3 rounded down).  Its present dividend yield is 3.16%, so assuming no change in this we can expect a one year price of 253 (=8/0.0316).  This gives a growth of 30% on the asking price of 190c that is available today.

Not bad, but a bit dangerous due to the untested nature of Amecor and the illiquidity of the share on the market.

Looking at it from a PE Model perspective could be misleading due to the lack of PE history and the lack of real comparative companies.  Altron is fundamentally different to Amecor, but lies in the same general industry as it, so it could be used as a vague yardstick.  Altron’s PE is 15.1, so risk adjusting it down we could say that Amecor’s future PE should come up to around 12.

Then, if profits are again 20% higher next year we can estimate a future price of around 289c (=20.10×1.2×12).  This would give an investment in Amecor bought at 190c a return on capital of 50%, but once again is dependant on both an increase in profits and an increase in the PE ratio as investor confidence in the company rises.

In all likely hood, it looks like Amecor is a dividend play with the growth aspects of an inelastic consumer product.  I like its management with their apparent cashflow sense and their support for minorities and I like the sector and the profit margins it supports…I just don’t like the lack of liquidity of the share.

As investor confidence in Amecor grows (along with its PE raito) and as the 6,000,000 shares issued to boost liquidity begin their movement around the liquidity should begin to become less of a problem.  Thus the liquidity risk premium demanded by investors should become less and the price of the share should actually grow faster than the growth of the company.

This makes Amecor really a “value play”, but I also like its growth prospects.  Ignoring the illiquidity factor, Amecor has nearly no debt, which makes it quite safe financially.

So, with all of this in mind, I have decided to label Amecor a conservative buy.  Perhaps a good option for diversification…?

Thus Amecor is a buy. 

Kind regards,

Keith McLachlan

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