personal investment blog

Calmly seeking companies with long-term strategies

Calmly seeking companies with long-term strategies

6 Dec 2013

It may seem odd but it is harder than you might think to find companies with clear and measurable strategies. It is depressing how many listed companies offer nothing but a “mission” to be the “best of class”, to be “passionate about their customers” (yuk) and to pursue “value for all stakeholders”.

In these challenging times when (thanks to QE) all assets are being priced as if they offer outstanding long-term value, I am inclined to seek companies with reasonably clear medium to long-term strategies. These generally feel obliged to keep their shareholders up to date with progress. Their executives generally accept that their careers depend on their achievements. If the strategies are realistic, they should be quite easy for investors to understand.

To be fair, it is easier for a business to offer a clear strategy if it needs to undergo some kind of transformation. It is tougher for e.g. Coca Cola whose strategy understandably consists of flooding ever more of the world with its yummy syrup. The same could be said of Microsoft which has torched billions and billions of dollars trying to add other products to its ubiquitous desk software. There is no call to criticise successful businesses for failing to reinvent themselves – all we need to do is to check their attitude to shareholder value.

But if we want to make serious money we should be looking for successful transformations.

The simplest but most dangerous transformations are those, like Enterprise Inns, that involve financial rehabilitation. Share investors can be well rewarded if the equity portion of the business rises as the debt decreases.

The purpose of this piece is different. It is to look for companies that are taking on the challenge of adapting their business model to changing times.

Beware of companies that focus purely on financial targets, especially when these are linked directly to executive remuneration. A German company that I once followed made a quite inexplicable acquisition. While the company’s core business was in software with an operating margin of 25%, it bought a ragbag IT service company with a margin of approximately 0%. The justification offered by the management in defence of the deal was so feeble as to be close to nonsense. It took me a long time to realise that the deal added enough revenues to push the group sales through a long-term target that triggered potentially lucrative share option awards for the Batman and Robin who ran the company. Good for them but rubbish for shareholders. That deal was in 2009 since when, in defiance of a booming German stock market (+71%), the shares of this company have returned minus 10%.

Here are four suggestions of companies with seemingly plausible and comprehensible strategies.

UBM

UBM’s headline strategy is unpromising:

“Creating value through business connections”

This tells me nothing about what UBM does and just makes me wonder how you would go about destroying value through business connections. Though as it turns out, the changing nature of what UBM does is the whole point. UBM (once known as United Business Media and before that as United Newspapers) was an old technology media company. It owned newspapers, magazines and, at various times, TV companies.

In 2004, 73% of the company’s revenue was print related. It is now less than 10%. UBM’s main business is now in running trade fairs. Revenues from “events” were 14% of the group total in 2004 and are now 56%. Moreover the operating margin from events is >30% compared to a group average of 22%. And this is a truly global business. Although trade fairs are clearly subject to economic cycles, there is strong growth coming from emerging markets. UBM is market leader in China and also strong in India and Brazil.

UBM’s strategy seems straightforward, assuming that I have understood it correctly. The company has been largely moved from a declining business to a better quality area where every sale is a potential repeat – most trade fairs happen every year or two. It has just two executive directors who seem to be well monitored by a posse of rather well paid non-execs.

At 663p per share, UBM has an enterprise value of £2.1bn supported by operating cash flow of c.£200m. Given that UBM is largely a marketing company, capital expenditure is fairly trivial and it is able to raise its dividend regularly. The current dividend yield of 4% seems generous to me.

Home Retail Group

I have written about this company before but it remains my favourite example of clear strategy. It may be that its obviousness matches my intellectual capacity. My wife likes Argos because you can order online and collect from a town centre store at your convenience. This seems to both of us to be quite preferable to the Amazon leave-it-with-a-neighbour delivery model, particularly for people who work full time. If there is an absolutely direct competitor to the Argos retail model, I have not seen it (though – full disclosure – my personal interest in shopping is close to zero).

My favourite line from the Argos strategy presentation reads:

“Tablets and technology replacing laminated catalogues, paper and pencils”.

Who would argue with that?

The group strategy also sets out absolutely clear long-term targets. Internet reservations now make up 43% of Argos revenues. In FY 2017 the company says that this will have risen to 75%. The group will be investing heavily in refurbishing its stores. This is not an assumption on my part. I can say this because it has published capex plans for the next four years.

I must admit that my strong liking for this story could impede my normal laser-like focus on the numbers but, trust me, the numbers are still fine at 190p. My suspicion is that Home Retail Group’s share price has suffered from the prejudice of those who think that Argos caters for poor people. Someone described it as an internet retailer for people without computers. But the company lists John Lewis as a competitor. Differences of opinion are always interesting and often profitable.

Halfords

I have been a shareholder of Halfords for some time. The shares are volatile and I am definitely not in love with the company. But it is an interesting example of strategic reinvention.

Halfords stores were apparently infamous for their uninformed and unhelpful staff. They seemed to stock a ragbag of driving and cycling products. Cyclists of my acquaintance regard Halfords with disdain. There was also an apparently joyless range of products for campers. Only 18 months ago, a Which? Survey found that Halfords was the worst store in Britain.

Looking at the financial results, I can see why this might have been. Its operating cash flow margins were in the 15-20% range, which is pretty successful for a retailer. Dixons, another specialist retailer that people love to hate, would most years be glad to make 5%. Kingfisher, regarded as the best quality DIY chain, generally achieves a range of 5-10%. So, Halfords was perhaps a strong candidate for complacency.

Another potentially dangerous factor for Halfords is the weather. Clearly, sales of bicycles and tents will rise and fall depending on whether the spring is sunny or stormy. There is little that can be done about that. But the dangerous factor is that it provides managers with a ready excuse for failure.

Halfords was victim to a creeping crisis that seeped into its results. In early 2010, it moved into a related but new area with its acquisition of Nationwide Autocentres, a car servicing and maintenance business that had 223 outlets, largely found in central and south-eastern England. Unusually, the stock market approved of this deal (Halfords shares rose by 10% on the news). More typically, the financial targets announced at the time of the deal have been comfortably missed. EBIT was supposed to rise from £7.6m in 2009 to £20m in 2013 but it actually fell slightly to £6.3m in FY 2013.

Nevertheless, we are where we are and Halfords Autocentres now has 296 outlets and fits nicely into the need to restructure the group. You may have noticed a large amount of TV advertising aimed at promoting the Halfords autocentre brand.

There are now just two executive managers who seem to be very closely monitored by the non-executives. If anything, I worry that they might spend too much time ticking boxes. “Long-term direction and strategy” is the subject of two day meetings, is regularly reviewed and marked against targets.

A major priority for Halfords is the training of its employees. It aims to increase expertise and to reduce staff turnover. There is also a store refurbishment programme and, of course, a need to move into the digital world. 11.5% of sales are now ordered on-line.

Annual capital expenditure will increase from c£20m to £32-5m for the next three years. This is easily affordable (operating cash flow was £93m in the last half year) and it is good to see a company that actually wants to invest in its business. Compare this to Debenhams that appears to lack confidence in its own investment plans and therefore continues to spend its shareholders’ cash on buying back its own stock.

At 480p, Halfords is not compellingly cheap. Its dividend yield is 3.0% and its free cash flow yield is 7.5%. It has probably benefitted from a summer that was kind to cycling and staying in tents and long-term investors do not want to pay up for the weather. But the company seems to know what it is doing and is willing to be judged on that basis. One to consider for a rainy day.

Drax

Drax operates a power station in Selby, Yorkshire. It is converting the power station from being coal-fired to running on biomass.

“Biomass is biological material obtained from living or recently living plant matter that can be processed into electricity, fuel and heat. Biomass has been used for thousands of years and there are many forms available. The materials that Drax use include sustainable forestry and forestry residues, residual agricultural products, such as straw, sunflower seed husks and peanut husks, and purpose grown energy crops.”           Source: Drax website.

At present the company expects to convert the first of its six generating units from coal to biomass by the end of this year. A second unit is expected to be converted in Q2 2014.

The company raised £190m in 2012 from a share placing at 520p. It currently has net cash of £200m and financing in place to allow it to fulfil the necessary capex. In 2013 and 2014 it expects to invest £365m-415m after which the Drax site biomass investment should be complete. Annual operating cash flow of £260m means that this should be comfortable achieved and also allows for the payment of a decent dividend.

Drax says that it expects substantial EBITDA (which should translate into cash flow) growth from 2015 onwards.

There is some argument about the carbon neutrality of biomass and it is not universally seen as an ecological solution. But it seems to have been successfully adopted in the US and France and the UK government last week confirmed its subsidy price (it cut the subsidy price for onshore wind farms which are not popular in the Shires). So there is a good following wind (sic) behind biomass and Drax seems to have a chance to lead the way in the UK.

Drax is not a risk-free investment but it looks like a decent bet. Last month the company issued a trading update that said:

“Since publishing our half year results on 30 July, trading conditions in the markets in which we operate have continued to be good. We have also benefited from solid operating performance from our coal generating units and the performance of our first unit converted to burn biomass in place of coal has been encouraging. In addition, commissioning of our new biomass delivery, storage and distribution systems is progressing very well. As a result, we now anticipate that full year EBITDA and underlying earnings per share for 2013 will be materially ahead of current market consensus forecasts.”

At 755p the shares yield 2.6% with every prospect of materially better payouts in the years ahead.

4 comments

  1. Bill Austin /

    Hi Jonathan, four interesting companies. My thoughts, for what they are worth.

    UBM has been showing good performance over the last couple of years though one of the risks is that staff leave taking a major client with them which should be reduced as the company grows. I hear stories of bribery and corruption in the market perhaps at a competitor. Good for me.

    Home, in its Argos persona has an interesting strategy, at the moment its website is limited to its own products, when will they consider opening the site up as a portal for other companies? It can look a bit like a H.Samuel’s which is not a good image to project. Home as Homebase is a terrible place to visit, it reminds me of Woolworths just before it failed but with high prices and mandatory large volumes, let’s hope the revamp has some external advice possibly from B&Q. A mix of two areas I worry about retail and building but good cash.

    HFD has come a long way in the last few years with staff who know what they sell even if the products are a bit “meh”. I can see it have a good middle ground position. Good for me.

    Drax is a fascinating company as they have to skirt, guide and dodge the changes to government strategy. Their lawyers are not as bright as perhaps they should be but the guiding hand is a pretty clever woman (if Dorothy left I’d worry). The danger here is that with every strategic change they get close to betting the farm, so far so good. My other problem with Drax is the share price, if it were £5 I’d buy but £7.50 is a bit steep.

    • Apparently Homebase positions itself for women who want to improve home and garden, B&Q is aimed at men who want to do DIY and Wickes is for trade. Needless to say (for those who know her), my wife likes Wickes and B&Q. They all seem equally repellent to me….

  2. Bill Austin /

    Mrs Austin thinks Drax is too big to (be allowed to) fail. So maybe they are not betting the farm.

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