Thursday, March 07, 2013 6:21 AM / Yahya Alfa Bakar*
In view of the great discrepancy between the business fundamentals of a large number of companies and the prices of their common stock, and the underperformance in the business operation of others, I only deem it appropriate that I share my thoughts on two very distinct companies which I think I have an acceptable level of understanding of their economics:
Nestle Nigeria Plc – Grossly Overvalued
To attain value from an investment activity, a great deal of consideration must be given to the ability of the concerned asset to produce a cash flow (in 5, 7, to 10 years from now) that justifies the price it commands in the market place. When the level of that ability is conservatively calculated, the investor should pay no more than the calculated level for such asset. A disdain for this simple, yet profound, step would bring about a complete defeat to the very purpose for investing. The prevailing condition however reflects the opposite; we have a significant number of investors who purchase a company’s stock simply to take advantage of the irrationally high multiplier a greedy public will place on earnings. Consequently, rather than focus on what the company would do, we have investors in constant anticipation of what other investors would do. To consciously pay more than a stock is conservatively estimated to be worth in hope that it can soon be sold for a still higher price is purely speculation. And speculation places capital at great risk. While it could be very rewarding in the short term, it rarely provides a lifetime of substantial return.
The long-term economic characteristics of Nestle` Nigeria plc is, without a doubt, favourable – a point I dealt with extensively in The Seven Saints (1). The level of that, however, does not justify the prices its stock has sold for in the last 52 weeks. At the price of N900.00 (2) a share, against projected earnings of N30.00 (3), the stock produces a price-to-earnings ratio of 30.00. A factor I consider to be very important in evaluation process is the price-to-earnings ratio of a stock relative to the growth rate of the underlying business. To purchase Nestle` Nigeria at N900.00 is to assume that the company will consistently grow its earnings at an annual rate of 30.00 percent. But when industry conditions are considered, this becomes a thing that can not be achieved. The industry in which Nestle` Nigeria plc operates brings with it a lot of challenges that I think the company can easily overcome.
Competition however, would continue to be its major irritation. The Nigerian food & beverage industry, as a result of its benefits, has an intense level of competition associated with it. Nestlé Nigeria competes with Cadbury Nigeria plc, Nigerian Bottling Co, and Seven-Up Bottling Company – companies that are of similar magnitude to that of its operating efficiency. The company also competes with a large number of small and medium scale (but very proficient) food and beverage producers. What’s more, the competition gets fiercer everyday. It would therefore be unwise for one to think that the company’s growth will not be affected. This reasoning would, in the long run, become vivid. And when it does, the market would be forced to revaluate the stock to reflect the true fundamentals of the company. Often there is no correlation between the performance of a company and its stock over a few months or even a few years. In the long term however, there is always a 100 percent correlation between them. Thinking about Nestle` Nigeria , it is quite clear to me what will happen – the downward valuation of its stock. But when it will happen and to what degree it would happen is very much uncertain. At the point it becomes certain, I will advise investors to short the stock.
An investment in the stock at N900.00 a share gives an earnings yield of 3.33 percent. In view of the 16.00 percent average market rate of money, and the fact that the company’s earnings can not consistently grow at a rate that allows earnings yield come into parity with market rate, the investment undertaking adds no value to invested capital.
In valuation, earnings yield must always be viewed relative to the market rate of money. The need for this is because market rates are an opportunity cost to equity investments and they are mostly adjusted to reflect inflation (the chief economic reason for investing is to, at the very least, preserve one’s net worth from the effects of inflation. And when this is not achieved, such investment becomes an economic failure). If the annual rate of return from an investment is not expected to be over and above the prevailing market rate, such an investment must be ignored.
Aso Savings and Loans plc – For Greater Value
A N100 million investment in the common stock of Aso Savings and Loans plc at its 2008 opening price of N3.67 a share would now be worth approximately N13.62 million. The mortgage bank was first listed on April 25, 2008 with an opening price of N3.67 a share. From 2008 to 2010 however, its shares closed each year with a significant drop in price; thus ending the 2010 period at N0.50 a share – and remained stagnant at that level till the time of this writing. This downward movement in the share price of the bank since 2008 produces a cumulative loss of 86.38 percent in its market value.
Generally, there are two reasons for losses of such magnitude: (1) the irrationality of the market, and (2) the deterioration in the business fundamentals of the concerned company; the latter holds for Aso Savings and Loans plc. An in-depth look at the bank will give a great deal of understanding of its business activities and the basis for its present state.
The purpose for the establishment of Aso Savings and Loans plc is to provide mortgage and construction loans for residential properties. This function serves a very essential need, and amid the huge (and sometimes, daunting) deficit of home ownership in the country, the presence of the bank is nothing but timely. The mortgage bank has a total asset value of N86.23 billion with customers` deposits serving as a major contributor to its funding, 79.24 percent, while shareholders` equity capital accounts for a significantly lesser portion, 3.64%. (The historical contribution of these two items to the mortgage bank’s total assets has been similar to these present proportions. The residual portions are contributed by short and long term debt and other liabilities.) About 47.73 percent of the assets are attributed to loans and advances that are focused mainly on mortgage and commercial real estate loans. (4)
A look at the height at which management has utilized these assets is something that is of great significance: Over the last five years, shareholders` equity capital has reduced substantially from N5.04 billion in 2008 financial year ending to N3.14 billion in 2012 (5). This astounding episode is a direct corollary of the bank’s performance in 2010 in which it realized an after-tax loss of N3.25 billion. These losses, in turn, were spurred by the negative pre-tax profit margin of 31.24 percent produced. A little investigation will reveal a lot:
Operating income for 2010 period was N6.96 billion, compared to the N10.20 billion of various items that were charged against it – interest on borrowings, operating expenses and provision for losses; where operating expenses accounts for N4.12 billion. A closer look: these operating expenses, as reported by management, are made up of N2.48 billion of items that were not accounted for but stated as “other operating expenses”; whereupon “other operating expenses” amounts to over 60% of total operating expenses. The question therefore: “on what items were these expenditures made?”
Taking a look through Aso Savings and Loans books for the last five years, one would discover that management has maintained this attitude in its accounting. It is quite ludicrous to me to see that over fifty percent of the expenses attributed to a company’s operations, or to the operation of anything worthwhile, are not properly accounted for. It just doesn’t make sense.
The single major hiccup of the Nigerian investment community could perhaps be its nonchalant attitude towards information – the supply of it by business managers and enquiry by investors. Most managers provide information sparingly. And investors simply award favourable stock prices to companies with a good track record and companies that they think will make a dividend payment in the subsequent year; other companies are ignored. Had a little more interest been shown to all companies, business managers would have been forced to sit up and deliver as they should (in which case we would not have the sort of accounting we have today), and poor performing companies spurred to turnaround. This approach is good for corporate Nigeria and the prosperity of the capital market. Conversely, some naively think the function of detailed information enquiry is for the regulatory bodies: The duty of the regulator is to ensure that companies operate within the confines of the law; the duty of the investor and business manager is to ensure profitability.
The 2010 results produced a material adverse effect on the bank’s financial structure. Its current equity to total asset ratio of 3.64 percent shows weakness in the bank’s financial strength and stability. A business that owns 26 times as much liability as equity is the most vulnerable to adverse economic conditions. Equity-to-asset ratio of 7.50 percent is the very least a banking institution must have in other to be financially strong and stable. Given its business fundamental, the prospect of Aso Savings and Loans plc looks highly unfavourable; likewise the prospects of the investment of the holders of its stock. The wisest course to follow therefore, if stockholders must change their fortune, is to get directly involved. They, especially the major stockholders, must express their concern and seek what must be done to better the fundamentals of the enterprise.
Though the wheels of the Nigerian housing sector is clogged with various challenges, Aso Savings and Loans plc, still has a very fine chance of operating profitably. The management of the mortgage bank, has in the last five years, maintained an above average performance in its core mortgage lending business. Going forward therefore, it must focus exclusively on this area and strengthen its presence in it in other for the bank to be (and stay) profitable.
To do this however, more funds would be required. New equity financing has already been sought for by way of rights issue. But this should not have been the case as those funds should have been raised internally, from the bank’s operations, and not from the shareholders.
In my book, the only reason the management of a company should desire an incremental capital is when it has efficiently managed the capital that was first put under its control and is looking to increase its capital base in other to grow and make the business more profitable when present capital is unavailable or insufficient for such activity. Capital should only be deployed into investment and business activities that will properly utilize them and should be (quickly) withdrawn from activities that will deplete them.
The Holy Scriptures concur: A man embarking on a journey called his servants and entrusted his property to them: to one servant he gave five talents of money, to another two talents, and to another one talent, each according to his ability. At once, the one with five put his to work and earned five more. So also, the one with two talents earned two more. But the one who received one talent did not put his to work and so made no gain. On the master’s arrival, he inquired about the reports and accounts. Upon this, he realized the results attained and then acted accordingly. To the two servants that made gains he gave more but to the one who made nothing he took the one talent under his management and gave it to the one with ten talents. The master’s remark: “....everyone who has will be given more and he will have in abundance. Whoever does not have, even what he has will be taken from him” (Matthew 25:14-29).
As the now wealthier master deemed it fit to increase the capital of the servants who made the best use of it and did not deem it fit to do the same with the third servant, so also must investors be willing to grant additional capital to businesses that increase their value and be unwilling to do the same for businesses that do the opposite. This should have been the mindset of the shareholders of Aso Savings and Loans.
Management should have sold some of the bank’s assets to raise those funds. I will go so far to say that they should have sold the entire investment properties for this purpose. And the reason for this idea is this: the bank’s property holdings are the least performing assets of the three main components of its total assets. Furthermore, Aso S&L is in the business of providing mortgage and construction loans for residential properties, not in the business of property investment and/or development. And at 11.80 percent of the bank’s total assets, its presence is at the detriment of the core operation.
Irrespective of the outcome of the rights issue, I would suggest that the divestment be made and the proceeds should be used to grow the core business in other to improve earnings and strengthen the bank’s financial structure. Management must not put the bank’s funds in asset that are underperforming over one that is doing well. But if the current situation remains, the mortgage bank would be running on a treadmill. Loss of capital would occur; whereupon new equity funding would be required. And this circle could go on and on. Won’t it, therefore, be wise for management to take the right step now and save the bank from this dismay?
The ideas and opinion expressed in this letter are my investment and business philosophy, they are not necessarily consensus. I however do believe that they are sure to bring a great level of success if adhered to. Thank you for reading.
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