London Value Investor Conference 2015 - Part 1 - Simon Denison-Smith - Metropolis Capital

Once again this year I had the privilege of attending the London Value Investor Conference (“LVIC”), for the third consecutive year – thank you to the organisers for laying on such a superb event.

It was held last week (20 May 2015), at the QE Centre, opposite Westminster Cathedral – the same venue as UK Investor Show – but it targets a different audience, of mainly city professionals, family offices, hedge funds, etc.

So as I always say, LVIC is very much the Rolls-Royce of investor conferences – expensive, but top notch speakers. I think all value investors should try to get along to this conference, even if it’s just once. After all, most of us wouldn’t bat an eyelid at losing £ 800 on a trade, but very few are prepared to pay that amount for a conference which would give a valuable education, and an enjoyable experience.

The event also raised over £30k for a tremendously worthwhile, but small charity, Child Bereavement UK.

LVIC is organised by Metropolis Capital. I first came across Metropolis in 2009, when the CEO of a Brighton-based listed IT training/staffing company called FDM, was trying to bully shareholders into accepting a dismally low takeover bid from himself and a PE backer. Being an FDM shareholder, and realising that the company was woefully undervalued, I wanted to stop the takeover bid, so I ended up speaking to Metropolis who were a major shareholder in FDM.

Confidentiality considerations mean I won’t go into any detail on those conversations, but I was struck by how smart the guys at Metropolis are, and they certainly influenced events such that the price of the FDM takeover offer was improved a couple of times, helping all shareholders, including me.

FDM has since returned to the stock market, at a valuation many times that which it was bought out at. So, on principle I will never buy shares in this company again – having seen how management shafted shareholders in the past, grabbing the upside for themselves when things were going well – I see them as unscrupulous, and hence uninvestable.

Each year, either Simon Denison-Smith, or Jonathan Mills of Metropolis give a talk at LVIC about their in-depth research process, and go into detail about one or two of their favourite shares at the time. So I thought it would be fun to check back and see how they have fared!

In 2013, Simon highlighted Cisco Systems Inc (NSQ:CSCO) as one of their favourite shares. I did a write-up of that talk here on Stockopedia, which is worth a recap. At the time, on 9 May 2013, Cisco shares were $21.10, so what are they now, two years later?

Answer – they are $29.26, a healthy gain of nearly 39%.

With the “internet of things” being much talked about, I think Cisco could be an interesting share to research again now. I will ask Simon to confirm if he is still bullish on Cisco, and update this article with his response in due course.

Stockopedia covers US stocks now too, and I can reveal that Cisco currently (at 23 May 2015) has an extremely high StockRank of 97.

Also, please note from the usual Stockopedia graphics to the right, that Cisco has high quality scores, yet the valuation seems reasonable, even low, at a fwd PER of 12.9, and a healthy dividend yield of 2.85%.

Cisco’s balance sheet is very strong too, with substantial net cash. So it ticks most of the boxes I look for, apart from being about 1,000 times bigger than most companies I look at!

At the other end of the valuation spectrum Simon mentioned this Scottish, family-controlled property company, as a minnow stock that they liked. The reasons given were mainly a large discount to book value, plus hidden assets, and a good underlying free cashflow yield.

These shares were about 83p at the time in May 2013, and are now 103p, so a relatively modest increase of about 24%, plus dividends.

My opinion – I’ve had a very quick review of the most recent accounts, and it seems a bizarre company – with a huge asset base, which is generating very little overall return. However, the discount to NTAV is striking, so there’s latent value in this share, but where’s the catalyst to unlock that value? If the family are happy just tootling along as they are, then there’s nothing outside shareholders can do.

Share buybacks are underway, so at least that provides an exit route for stale bulls, but is only going to make the shares even more illiquid.

However, if you’re happy to just receive the 2.85% divis, and leave your capital tied up for possibly years, in the hope that one day a catalyst for unlocking the asset value will appear, then this could be worth looking at.

At last year’s LVIC, Jonathan Mills of Metropolis gave a talk called “Owner Occupied” (which I missed unfortunately, but I have a copy of the presentation slides) about the advantages of investing in founder run businesses.

Jonathan explained how businesses which are still run by their founder entrepreneur tend to display attractive traits.

At the start-up stage:

Entrepreneurs are formed by their early experiences.

All start-ups experience similar conditions, irrespective of their industry;

• Shortage of capital
• Short term sacrifice by entrepreneur (e.g. little to no salary, long hours)
• Sales dependent
• Have to adapt to survive

Founder run businesses tend to be:

• Long term driven
• Good capital allocators
• Customer focussed
• Restless innovators

So start-up conditions tend to forge the DNA of owner-occupied companies, and makes them good companies to invest in.

My opinion – this strikes a chord with me. Two of the most successful investors I know, Lord Lee, and David Stredder, attribute a lot of their success to taking long-term positions in family-controlled companies. So this is definitely an area I’ll be paying closer attention to.

It’s not a guarantee of success of course, and particularly with micro caps, you can end up in a company where the family derive most of the benefits, from jobs amp; sometimes high salaries, with minority investors receiving little, if any return.

So careful scrutiny of the track record of the family, and how they treat outside shareholders, is vital.

The example given at last year’s LVIC by Jonathan Mills, is Admiral. Here is the slide introducing Admiral amp; it’s owner-occupied credentials, NB this slide is now a year old;

So apart from being owner-occupied, what did Metropolis like about Admiral (LON:ADM) this time last year?

• Potential from overseas expansion – small loss maker now, but large potential upside
• Long-term stability afforded by co-insurance with Munich Re
• Investment of float is conservative – entirely in cash, long term deposits, money market amp; short term debt
• Low cost model is Admiral’s moat – combined ratio is materially lower than average
• Low expense ratio is key to Admiral’s competitiveness
• Lowest staff costs, but pay staff more in equity than other insurers
• Low staff turnover – Admiral rates very highly in staff surveys
• Management are sensible capital allocators
• Pays big dividends instead of hoarding cash
• Customer-centric business model (but doesn’t everyone say this?!)
• Restless innovation, e.g. multi-car policies, creating new brands (e.g. elephant.co.uk)
• Low PER of 13, in May 2014
• Normalised PER of 10.5 in May 2014

Result so far - In fairness, it should be said that one year is far too short a timescale, as Metropolis pick shares with a very long term horizon.

That said, the shares are now 1478p, so have gone up about 8.8%, plus divis of say another 7% on top from the purchase price – not a bad one year total return of about 15.8% before tax.

As you can see from the chart below, Admiral shares have usefully out-performed the FTSE 100 Index (beige comparison line) in the last two years. I wonder what caused the recent sharp dip?

My opinion – I don’t have one, as Admiral is not a share I’ve looked at before, but it sounds interesting, and may be one I’ll take a look at. The divi yield is showing on Stockopedia as a very attractive 6.1%.

Although I note that broker earnings forecasts have been steadily declining in the last year, which would need looking into. Competitive pressures biting maybe?

Moving to this year’s conference, Regus, the serviced office company, is Metropolis’s favoured stock pick for 2015. This may sound surprising, for a value-seeking fund to be flagging a company with no net asset backing (last reported NTAV was -£12.5m), huge lease liabilities (it rents long term, and sublets short term), which has previously almost gone bust in a recession.

However, there is method in their madness! Metropolis modelled Regus, and noted that it is only by year 4 that new offices make a profit. So in periods of expansion, such as now, the losses from new sites obscure the profits from established sites.

Metropolis calculate that the free cashflow yield is over 10%, at the current market cap of £2.4bn (at 257p per share). NB this is based on their own calculations, based on established sites only, so it won’t tally with the published figures, where new sites obscure the cash generation of older sites.

Owner-occupied – following their theme from last year, Metropolis like founders to have a large stake, and Mark Dixon owns 31.4% of Regus, so a big tick in that box.

Metropolis note that Dixon is an efficient capital allocator – he won’t open new sites in areas where the property market is too hot. If he can’t secure his target ROCE, then he walks away from deals on new offices.

Dominant in sector – Regus is 13x bigger than its nearest competitor.

Moat? – the worry is that there is little to stop competition. However, Metropolis talked to people in the industry, landlords, etc, and came to the conclusion that Regus has “lots of little moats”, e.g.

• Dominant web presence
• Global clients come to Regus first when they need space (e.g. Toshiba, Google)
• Good (property) broker relationships
• Expensive items like sophisticated IT which competitors might struggle to offer, generate 40% of Regus’s income
• Ability to drive down the cost of sites, especially in a downturn
• Scale advantages (e.g. management, fit-out costs, IT)

Cyclicality - this is the big risk to Regus’s business model. Regus almost went bust in 2000, and made losses in 2007-8 too. So at this point Metropolis almost abandoned the stock idea.

However, they noted that Regus remained profitable in the USA in 2007-8, and wondered why. It turns out that in the USA it was structured using lots of Special Purpose Vehicles (SPVs), ie. separate subsidiary company with no parent company guarantees – thus ring-fencing liabilities on any problem sites.

This USA model is now being rolled out in the UK, and elsewhere. What this means is that when the next recession bits, Regus will have the capacity to go back to landlords of loss-making sites, and negotiate a lower rent (usually in return for a longer term). If the landlord says no, then ultimately the SPV which operates that site can be liquidated, and the parent company walks away with no liabilities.

Taking this into account, Metropolis believe that with the stock currently at 10x its adjusted earnings estimates (the PER is much higher for the reported figures), then they reckon trough earnings in a recession might be roughly half current earnings, which is the experience of the USA company, which remained decently profitable in 2007-8. So 20x trough earnings is a price that Metropolis are happy to pay now.

Price target - Metropolis reckon that Regus shares are worth 370p assuming no further growth, 470p with 10% growth modelled, and 520p with 15% growth assumptions.

The shares are presently 257p, so the targets above offer potential upside of 44%, 83%, or 102%. Not bad going, if this analysis does turn out to be right.

Conclusion – Metropolis describe Regus as a “rare bargain in a difficult market”. By difficult they obviously mean relatively expensive I’m guessing.

92% of offices are now in the SPV structure, so the new business model is already in place, which should enable Regus to fare much better in future recessions.

My opinion – I don’t know enough about the company to comment, and bow to the detailed analysis done by Metropolis. The strong up-trend in share price lately, and the apparently high valuation (21.5 times broker forecast earnings, and only 1.8% divi yield) suggest that other investors have done similar sums to Metropolis, and are hence willing to pay up for the shares given that the business model has changed, and that underlying profitability is greater than reported profitability, and now more resilient to be capable of holding up better in future recessions.

So an interesting situation, that might be worth doing some more research on, in my view. Although I’d struggle to buy now, after such a good rise recently – I might put it on my watch list and buy on a big dip though.

Personally, I find it very interesting to hear the research process that accomplished value investors take, as much as their stock ideas. These guys are always interesting to listen to, and I think it’s important to flag that their stock ideas tend to be lower risk – so holding these stocks in a downturn will probably give relative out-performance, whereas they might not necessarily out-perform in a bull market, when investors are often chasing more flaky, speculative stocks, and ditching their value shares to finance that. Of course that approach always comes badly unstuck on big market falls.

So thanks again to the guys at Metropolis for organising LVIC.

I hope to do one or two more articles from the conference, if readers find this article useful. If they don’t, then I won’t bother amp; will spend my weekend doing something else!

Regards, Paul.

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