Valuation – Digicor

Independence: No, I don’t own DGC shares

Digicor provides and disseminates critical information to its customers for the efficient and effective management of their mobile assets—like vehicles and their cargo—for both logistical and security purposes utilizing technology.  Basically, Digicor helps its clients save money on fuel and security by offering fleet tracking and coordination software and hardware.  With the oil price sky-high, this is a booming industry whose growth is reflected by the recent 57% growth in profits of Digicor for the year ended 2006 as compared to the 2005 year.  But, all of this is historical news and has long since been factored into the share price.  The only question now left is whether or not DGC is still worth buying?

With a market cap of R758million it could well be called a mid cap, but its recent growth in earnings places it into the potential growth stock category, thus I will still attempt to value it.

Digicor started paying dividends a few years back (with its virgin 2c DPS in 2003) and since then its dividend growth has outstripped its earnings growth to the most recent 2006 DPS of 10c.  But, the share price has also rocketed from a low of 15c in 2003 to a high of 390c on 6/09/2006.  Hence the dividend yield has dropped from 8% at the closing price of the 2003 year of 25c (=2/25) to the present 2,7% of today (=10/375).  Thus, although Digicor may once have fallen perfectly into the Small Cap category, the real question is do they still?  How much growth can we still expect?  Or have they reached the maturity of a healthy mid cap with appropriate growth and related investment returns.

Their PE ratio has grown from a very low 3.12 at the end of 2003 to the present day 11.8.  So it is reasonable to expect that next years PE will be between 12 to 14…if the market factors in the time value of money as applied to earnings.  Lets make it 12 to be conservative.

EPS for the year ended 30 June 2006 has been forecast at between 45% and 55% higher than last year equivalent EPS.  It ended up being 57% higher.  Last year 12 month EPS was 32.3 (HEPS = 31.9), so if the growth in the twelve months ended 30 June 2006 EPS carries through to the next twelve months year then the 2007 EPS can be forecast at 48cps (=32×150%).  Given a conservative PE of 12 a forward one year price can be seen to be 576c (=12×48).  This gives a return of 53,6% on an investment bought at 375c, excluding all dividends.  So, it sounds like it would be an excellent investment.

As Digicor pays dividends it is also worth using the Dividend Growth Model, but the problem is two fold: it does not have constant growth and its Cost of Equity (which I calculate at 16,8%) is greater than its present growth rate of 30%.  Thus, using a modified dividend yield I can assume that the future DY will pan out at about 2 to 2,5% (which the market will then factor in all future growth into this) and that next years dividend will be around 13 to 14cps.  Let’s say its 13cps with a DY of 2,3%.  Thus the forward price is around 565c (=13/0.023).  This appears to back up the PE Model used above.

The question is will the 2006 growth rate continue into the 2007 year?

Looking at Digicor’s balance sheet it has a conservative D:E ratio of 0.31, an interest cover of negative 31.49 (i.e. it earned more interest than it paid), and a dividend cover of 3.23.  A very healthy picture indeed for a growing firm.

Recently Digicor sold a wholly owned subsidary Digicor Fleet Management (Pty) Ltd to another 70% BEE empowered subsidiary, effectively disposing of a 30% interest in this company.  This will help it secure BEE contracts, but it looses out on 30% of that income.  This sounds to me like a zero-sum game that DGC has play in order to comply with the BEE codes and should be pretty much discarding in valuating DGC.

It also recently won a large contract from the eThekwini municipality, which is probably the product of the BEE deal mentioned above.  Once again, too little information on the contract has been released to the public to factor this into this valuation.

So where to look for signs of growth?

Well, the profit margin has creeping up from a small 9.71% in 2003 to the healthy 19.84% in 2006.  Turnover has also grown significantly in line with the margin growth.  This all points to an increasing demand for its products and services and the resulting returns to it scale that it is experiencing from this expansion.

Added to this, in the long-term oil is a limiting factor in the world economy and is only going to get more expensive.  So more and more firms are going to looking for ways to save and manage their fuel requirements efficiently.  This makes Digicor perfectly placed, but will also attract competitors.

Due to all the above factors I believe that the 2006 growth will not be seen again, but that a more reasonable 30% growth in 2007 will occur with a gradual slow down from there onwards.  The problem is that the Funds have started moving into DGC, thus squeezing the returns on its share (hence the dropping dividend yield and increasing PE ratio).  There are a limited number of funds and a limited amount of funds.  This means that the share may well have overextended itself in the long-term and as competitors wade into Digicor’s fragile market the DGC share price plateaus.

Over all, I feel that DGC is as safe as a large small cap can be and is a good buy—if properly timed—for the next 2 to 3 years, but I would not look beyond this.  It is a growth stock in the process of maturing.  Hence it is labelled with a conservative buy rating from www.smallcaps.co.za.

Kind regards,

Keith McLachlan

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Valuation – Esor Ltd

Independence: Yes, I do own Esor shares

 Esor, listing just after WG Wearne, is one of the recent additions to the AltX’s building and construction sector.  In its own words Esor is in the business of “…culvert and pipe jacking, piling, thrust and auger boring and civil engineering.”  With the present boom of the local construction industry in South Africa and the governments commitment of billions of rands to it, Esor is perfectly placed to leverage the sectors peachy future.

 The shares were listed at 100c and went over 200c on the first day of listing.  They are presently trading within a range of 240c to 260c.

 When the maiden results of Esor came out for the year ended 28 February 2006, they had actually beaten their forecasts by over 30% and registered EPS of 13,3c and HEPS of 12,7c, as compared to the previous years earnings of 6,1c and 6c respectively.  This shows an increase of more than 100%!

 They have recently made an acquisition of a rival firm—Franki Africa—that was paid in part cash and in part by issuing shares in itself at 160c per share.  The share price at that stage had reached around 290c and came tumbling down to as low as 225c upon the market hearing this news.  I feel that market’s initial reaction was motivated in part by the price tag that Esor placed upon its own shares of 160c.  This number—being quite a bit less that market price—may have made many doubt their valuations of ESR, thus panic selling driving the share further away from the SML and into the bargain hunters realm.

This reaction, was overly emotional, as witnessed by the firming of the price back up to the 240 to 60c range.  If the market had spent a second to think about things they would have seen that the reason Esor issued its shares at that price was because of the immense benefits that the complex deal unlocked.

Firstly, Esor—a skill driven business whose main assets are its people and the skills/experience they have—had bought a competitor and increased its number of skilled employees/skill base.  Franki also has a different geographical base to Esor and operates in a number of foreign countries, thus Esor had purchased diversification too.  Franki’s services included some that Esor did not, thus Esor had purchased an extended product range.  To top it, the purchase pro-forma adjustments show that—if Franki had been bought last year—it was instantly augmenting of shareholder earnings!  I.e. Esor bought more profits than it paid for with shares.

Secondly, Esor issued shares to a BEE partner at 160c that gave them a 25% empowerment status.  In construction contracting this is a vital vital vital number to reach.  This is because the greatest source of revenue for these companies is the government and the government gives preference to empowered companies.  Esor, essentially, opened the door to lots of future potential contract revenue.

And to top it all off, the cash generated by the share issued was the cash that Esor used to pay for the cash part of the Franki acquisition, meaning that it didn't pay out of pocket.  Its working capital and reserves remained untouched.

 Added to this acquisition is the fact that Esor, only a four months into its financial year, has already met 70% of its R130million 2007 revenue forecasts.  Revenues, hopefully, translate into profits.  In this case, it would be reasonable to calculate the effective grossed up revenue for 2007 as 130×70%=91…91/4months=22.75… and 22.75x12months=R273million revenue for 2007! That’s more than double the forecast revenue (110%)!  I won’t use these numbers below, but if I did then I’d say the expected growth in EPS was 110% I’d get a fair value for Esor of 419c (13.3×2.1×15)!

 Now, down to the conservative calculations.

 I feel that an adjusted PE using historically adjusted earnings will be the best tool to value Esor.  This is because being a construction/contract company its cashflows will be irregular, thus making a discounted cashflow valuation difficult and risky.  ESR doesn't and probably won't anytime soon pay dividends, so the Dividend Growth Model wouldn't be much help here.

 Growth in earnings of 118% caused 2005’s EPS of 6.1 to turn into 2006’s EPS of 13.3.  This of course was boosted by the increased working capital that comes with listing, so growth of that much for EPS of 2007 cannot be expected.  Already in a statement to the press the CEO said that 2007 EPS should beat last years by more than 19%.  I believe that Esor should beat its 2006 EPS by quite a bit more than just 19%.  This is partly because Esor beat its own original forecasts—so whose to say that it won’t beat the CEO’s adjusted forecast!—and partly because of the way the fundamentals look at this time.

 Franki augmented earnings by some 10% or so and, added to this Esor has most of its forecast revenue.  So, lets say that top level growth should be half of 2006’s, i.e. 50%  Now, the average between the CEO’s growth forecast and mine is 35% (50+30=70…/2=35).  Let’s use that as a yardstick.

 Also, HEPS 2006 = 12.7 and EPS = 13.3.  Let’s also take the average which is 13cps.

 The PE multiple could be tricky, as it always is for a fast growing company, but lets look at sectors leaders: Aveng’s PE = 17.8; M&R’s PE = 19.7; and WBHO’s PE = 17.3.  So, let’s say that the average is around 18.

Now, adjusting the PE down for the added risk of investing in a small cap, the lower liquidity of the share, and the lack of dividends we could say that a PE of 15 would be reasonable.

 So, the value the share should be trading at now and in the next year or so can be calculated as PE x Expected EPS.  In this case that is:

 13 x 1.35 x 15 = 263.25c

 The share is currently trading at 250c, which 5,3% below this value.

 Now, let me remind you that I used a conservative growth value and an adjusted PE of about 20% lower than the blue chips.  If you were to be optimistic then with EPS of 13.3, growth rate of, say, 50% and a PE of say 18 you would get a fair value per share of 359.1c (13.3×1.5×18)!  43,64% above its present price!

 Bear in mind that this is a very optimistic valuation…but also note that we have not yet seen what synergetic and earnings augmenting the consolidation of Franki will have in Esor’s future results.  Also, remember that I am looking just one year ahead at the value, Esor will probably continue to grow at a pace outstripping most other shares beyond that.  I feel that it is thus an excellent growth play.

 Given all the potential and despite all the risks and uncertainties, I feel that Esor should be labelled a www.smallcap.co.za buy for the next 3 to  years…but, of course, make up your own mind about that.

Kind regards,

Keith McLachlan

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Valuation – Taste Holdings Ltd

Independence: No, I don't own this share

Taste Holdings (TAS) is basically the holding company for Scooters Pizza and Maxi's chain of restaurants.  This places them well into the fast food industry, which is important to bear in mind when comparing against competitors and in reviewing their risks.

Before I even begin to value TAS, let me state here that any company is only as good as its product/service.  In TAS's case this is mainly pizza and hamburgers, which is easily comparable to its competitors and consumers can easily switch between brands.

I prefer Debonair's pizza to Scooters…and if I do, then I take a bet that most other people do to.  The prices are basically the same, but Debonairs just has a better taste and a nicer "flashier" image.

So, Taste is the franchise holding company of Scooters pizza and Maxi’s restaurants and in their prospectus they go on and on about the bright future of their two products and they go on about how many they plan to open up in South Africa.  They further state their marketing strategies and how South African’s disposable incomes have increased (with the low interest rates) and the higher income and busier lives consume more fast food.  In my opinion they are attempting to justify an aggressive listing price with a rather high PE ratio.

Bear in mind that the interest rate has stopped dropping and has begun to rise.  Higher interest rates makes for higher interest payments makes for lower disposable income.  Bad timing for Taste; sorry TAS shareholders.

It opened at 90c, touched 90-something cents, and then plunged below issue price.

The other thing was that they raised a couple million before coming to the market by issuing shares at 90c each.  The CEO said that this was at PE of 15, which is comparable to Famous Brands (Taste’s competitor that owns my preffered choice: Debonairs and Wimpy).  The problem is that the price of 90c was reached by using next years earnings!  Also, Famous Brands a far safer to invest in than Taste is…so you cannot use the same PE multiple!  Basic finanace: use the same earnings period for your PE calculations. Also, you’ve got to factor in risk!  Famous Brands PE is historical, while Taste's if a forecast one.  Famous Brands PE is for a secure company, while Taste's PE is for an unproven one.

So, let’s say Taste is only marginally hurt by the interest rate hike and EPS are around 5.5c and let’s factor the PE down to a more reasonable 12 (actually, I think 10 is more realistic given the risks).  That makes TAS worth 66c.

That’s less than the present 77c it closed at today. 

Far less.

Add to this that the Maxi’s brand has a very "cheesy" and confused marketing campaign: are they family restaurant, a budget restaurant, or a half-way house?  I just don’t understand the brand and if I don't then there is a good chance the rest of the market won't.  Also, how it is going to steal market share from Wimpy and Steers and Saddles and…the list is nearly endless. 

There is just too much established competition in this sector.  I prefer companies in less competitive industries…and this is not one of those industries.

Add to this the fact that Taste has a small NAV per share of around 19c and an even smaller tangible one.

And add to this the lack of liquidity of the share.

I have to point out two small rays of sunshine amidst all this criticism: the directors have bought lots of shares on the open market and Taste does not actually own the fixed assets of the franchisees.  This makes it very capex light, which means lower risk, faster growth, and greater ease of expansion…possibly also more free cashflow for future dividends.

Despite the insider buying and the capex story, I would not buy TAS shares at 77c.  I might buy it if it went down to 50c, or 30c…or 1c…but definitely not at 77c. 

Thus, SmallCaps.co.za labels Taste a sell.

Kind regards,

Keith McLachlan

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