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Have I fallen in love with Capilano Honey Limited? (ASX:CZZ)

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Introduction to iCar Asia (ASX:ICQ)

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Speculative stocks

2018-08-14T09:20:00+00:00

Is LifeHealthcare (ASX:LHC) a dividend play with upside?

2014-09-12T00:51:34+00:00

Please note: this report is very old to the point where it is useless. You must not consider it to be current. Many things may have changed, and it may well be that I no longer believe this company to be an attractive option. Please consider it an archive only.

It’s no secret that the ageing population will result in gradually increasing expenditure on healthcare for the next 3 decades. However, it’s relatively rare to find a company that is exposed to these trends, already pays a decent dividend, and is not exorbitantly priced. LifeHealthcare Group Ltd (ASX:LHC), which listed about 9 months ago, appears to be one such company.

I bought a some shares of the company at $2.33, just prior to the ex-dividend date, which was 3 September 2014. I wanted to wait until I'd spoken to management before writing about it, although that was more than a week ago now. The price is now $2.42, which, taking into account the dividend , is effectively 7% higher. It kinda got away from me there. What can you do?

On a lighter note, I did speak to the CFO David Wiggins who treated me with kindness and gruffness with lashings of respect. I think this is a good sign. We didn't speak for long, but he passed my basic interview test which is - can you talk about everything I don't like about your business without being rude to me? You would be surprised at how many companies' management cannot pass that test, and indeed I sold down another position recently for that exact reason. But I diverge...

What is the business of LifeHealthcare Group?

LifeHealthcare is in the business of distributing medical devices such as the robotic systems used for spinal surgery as well as the plates that surgeons implant to hold spine grafts in place. The company has historically grown by acquisition and is likely to continue on that path.

Shareholders are likely to benefit from private-public arbitrage, that is, the fact that the company can acquire smaller unlisted businesses at a discount to the going rate for a similar publicly listed company. On top of that, operating expenses can be stripped out of acquired companies.

The company is right to expand into hip and knee replacement devices and coronary stents, because demand for these devices is extremely sensitive to the ageing population. The simple fact is that the elderly are more likely to need a hip or knee replacement after a fall, or a coronary stent after a heart attack. Demand for these products is sure to grow steadily – the challenge for LifeHealthcare is to capture some of that market.

Although the business is not particularly exciting, the fact that it already distributes around 50 different products means that its fortunes do not depend on the popularity of any one product. Indeed, as the company offers new products, it becomes a more defensive investment because its revenue streams become increasingly diverse.

Who is running the show?

The CEO Daren McKennay founded the company and still owns about 3.4% of the shares, despite divesting some in the IPO.

According to the CFO David Wiggins, who also has a meaningful shareholding, LifeHealthcare has “focussed on moving into high-end device product areas” over the last 6 years. This is important because the company has more pricing power with high-end, clinically differentiated, products. Put simply, surgeons will encourage patients to pay more for top-of-the-line implants, and prefer to use the best equipment when operating.

The acquisition strategy is to focus on expanding existing clinical channels. For example, the company already supplies cardiac ultrasounds to heart surgeons, and will use existing relationships to market implantable coronary stents. Similarly, the company will leverage its existing repair and replacement sales channel to expand into primary implants.

What are the main risks?

As an importer, the company will have to increase prices if it is to maintain margins as the Australian Dollar weakens. In any event, a high Australian dollar benefits this company, and a weak Australian dollar hurts it. Although the company uses hedging to smooth the impact of currency fluctuations, if it turned out the company has insufficient pricing power to adapt to a lower Australian dollar, that would hurt the thesis.

An inflationary environment would also hurt the company, which has to fund inventory and is rather capital intensive. This is not a business with what I call "good economics." However, because it is planning to expand into hip and knee replacement, there is a good chance that this ugly duckling can turn into a swan. If not, well, ducks can be pretty beautiful if well looked after.

The other main risk is that the company pursues earnings growth even at unattractive rates of return. It is therefore important to monitor any acquisitions, especially while the balance sheet carries debt, because management is incentivised to grow earnings per share, rather than to achieve a high return on capital invested. I would view a significant increase of debt unfavourably, and I would get really annoyed if they paid more than 7 times EV/EBITDA for an acquisition. I'd also get really annoyed if they acquired a distributor that didn't have clinically differentiated (and sometimes superior) products.

Shall we look at some numbers?

LifeHealthcare is targeting a dividend payout ratio of 50–70% of statutory NPATA subject to working capital and capital expenditure funding requirements. NPATA was $7.5 million in FY 2014. Assuming that figure remains flat (a conservative assumption in my opinion), then the forecast dividend yield for FY 2015 is 3.5 - 5% only partially franked. However, I would consider the likely total dividend yield at the current price to be in the vicinity of 5 - 6%, partially franked, likely to grow.

In recognition of the fact that my discounted cashflow valuations are a black-box that no-one understands, I'll show you a more traditional DCF valuation for LifeHealthcare. However, please note that that this is one of about 20 valuations I did with different inputs. My use of discounted cash-flow valuations is in order to apply the Pabrai philosophy of heads, I win, tails I don't lose much. The big winning part for LifeHealthcare that as a business it should last more than 10 years. It's not the best investment I've ever made, but I considered it worthy of a position in my portfolio at an effective price of $2.26 per share.

The reason I've predicted so much growth in cashflow is because I think that growth in receivables ($3 million) was higher than usual compared to growth in payables ($1 million). Although, sadly, I'd expect receivables to grow over time in a business with poor economics such as device distribution, the fact that profit was higher in 2014 than 2015, but cashflow was higher in 2013 than 2014, suggests that the balance sheet movements had an impact. I've made some allowance for the ever-necessary capital expenditure, but have I allowed enough? I'm out on a limb because of this company's lack of history as a listed company.

What this DCF model proves, one way or another, is that the company is not cheap (by my fairly harsh standards) unless it makes some good acquisitions.

My reasoning is that the company has been built on acquisitions so far, and while we shareholders wait for them to do another good acquisition, we are paid a decent dividend. If the company does not make a good acquisition, then at least debt should be reduced a bit and so, therefore will risk. I am not overly excited about investing in a business that is not inflation resistant, but I am willing to give management a chance to show they have enough discipline to stick to the kind of "business channels" where they can maintain pricing power. I'm willing to wait and see if they can pay the right price for the right businesses. I see value at $2.40, and I stand by my decision to buy at an effective price of $2.26, though the impact of a falling currency concerns me.

It all comes down to faith in management.

The author owns shares in LifeHealthcare. The purpose of this blog is to document my thoughts on different companies in an easily accessible way and to make connections with likeminded investors. Subscribers to the Free Newsletter get sent research first, and have access to the Hidden Research.

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Is Kip McGrath Education Centres Limited a turnaround success? (ASX:KME)

2014-03-21T01:17:34+00:00

Please note: this report is very old to the point where it is arguably useless. You must not consider it to be current. Many things may have changed, and it may well be that I no longer believe this company to be an attractive option. Please consider it an archive only.

Kip McGrath Education Centres Limited (ASX:KME) is a tutoring franchise. Its key offering to franchisees is the cloud-based software package that allows students to submit their homework online and take lessons online as well as streamlining the process of reporting progress to parents.

However, this was not always the case: indeed, the company has recently turned itself around. To quote Chairman (and co-founder) Kip McGrath in the November 2010 Address to shareholders:

“Since the end of 2010 the company has encountered difficult trading conditions and is trading below last year…With the continuing strengthening of the Australian dollar… we are suffering a permanent negative effect on our revenue and profits… In the core franchise business new sales of franchises are very slow and it has been clear for some time now that an exclusively face to face teaching business that offers minimal administration and head office support to the franchisee is losing relevance in today’s tutoring market.”

Worse still, the company had invested in a business that lost money, and the business was liquidated by the end of 2010. Put simply, the company had purchased a college education business that generated losses and subsequently failed to gain re-accreditation resulting in an impairment charge of $2.5 million.

For these reasons, the business went through what can only be described as hard times.

Fast-forward to the present and the business is looking much better. The company has bolstered their online offering and changed the way they share profits with their tutor franchisees. This better incentivises tutors to focus on tutoring and generate more revenues. The new cloud based software (which allows students to work from home) is apparently improving student retention.

Because of these initiatives, the 2013 Chairman’s address strikes a very different tone: “It is gratifying,” he says “to see the company back on a path that I believe will see continued growth and expansion over the next couple of years.” Believe it or not, the company is currently opening centres in Qatar, Lebanon and Pakistan. While it is reasonable to assume that these markets may not be the most secure, most of the company’s revenue still comes from Australia and the UK.

KME Stock Valuation

Free cash-flow (not including financing costs, but accounting for changes in receivables and payables) in the 1^st half of FY 2014 was about $400,000. I think it is therefore reasonable to expect about $1 million in free cashflow for FY 2014. I then forecast the company to have a significant improvement of 20% for FY2015. This may seem outlandish, but given that the company has a degree of operating leverage, and franchise models are generally scalable, I expect that top line growth should really drive bottom line growth, especially given the capital light model model. I’ve then assumed slowing growth over the subsequent years. Another way to get the same value would be to assume 8% FCF out until 2021. 8% growth isn’t really that much more than CPI growth, so I think it’s a reasonable to expect. However, I’d be unhappy if FCF fell short of about $1.35 million in FY 2015. There are a number of valid criticisms of the assumptions I've made, I'm aware of some, but I hope some readers will make the criticisms in the comments (for the sake of us all).

The company still has debt of just over $2 million on the books, so I would adjust my valuation down slightly to account for that. Importantly, finance costs are about $260,000 per half and I haven’t subtracted this from free cashflow.

That’s because I wanted to value the underlying cashflow, not the real free cash flows. Adjusting for the repayment of this debt and taking into account cash (assuming they continue to reduce financing costs) I get a buy price of about 31c. As a result, I bought shares at 29c in recent weeks, and would buy below those levels. I also think Kip McGrath would be a decent investment at up to 35c, although I am not a buyer at those levels. I’ve often received feedback that I make overly conservative assumptions. I’ll just keep plodding along, and regular readers who better understand my biases will continue to get more use out of my research than once-off visitors. That’s as it should be.

DCF working

The sharp eyed amongst you will note that FY 2014 DCF value is only discounted by 5%, the other years are 10%.

Low Liquidity Stock

When I first started buying Global Health Limited (ASX: GLH) at 23.5c there was virtually no liquidity. After I covered the company on this blog, shares continued to trade under my buy price for several weeks, albeit on small volumes. Those market participants who patiently waited for their orders to fill were rewarded.

I may buy more KME, especially if the stock falls to about 25c. I noticed that there was a steady drip feed of stock at around 28.5c – 31.5c, so I suspect there may be a holder willing to part with shares at those prices (which is fair enough, considering how low the stock has traded in recent years). Low liquidity stocks are for high conviction holders only, in my opinion. The big question for Kip McGrath is this: will tutor franchises continue to attract new clients?

A lot of variables go into answering that question, and therein lays much of the risk.

The Author owns shares in Kip McGrath. Nothing on this website is advice, ever. The purpose of this blog is to keep track of my decisions and invite feedback

1300 Smiles Limited: Superstar in the making (ASX: ONT)

2014-02-17T09:16:38+00:00

1300 Smiles Limited (ASX: ONT) provides marketing, administration, billing, collections, finance, facilities, certification of facilities, equipment, and all consumable goods to a network of dentistry practices emanating from Townsville. The company also owns a practice in Adelaide. The company employs some dentists, but also allows dentists to remain self-employed. In the last 10 years, 1300 Smiles has never achieved Return on Investment of under 20%, and has averaged ROI of above 30%. While the company is facing the most difficult time since listing, I believe it will average ROI of at least 20% over the next 10 years.

Why would a dentist join 1300 Smiles?

1300 Smiles allows dentists to focus on dentistry, without troubling themselves with the various extra responsibilities of running a practice. Dentists can choose to be employees or self-employed, in accordance with their personal preference. Employee dentists have the comfort of a secure salary. Self-employed dentists pay the company a management fee on a sliding scale, such that they are incentivised to be more productive.

Marketing and brand recognition can increase the flow of patients to a self-employed dentist’s practice, and the financing options may increase the appeal of the practice. Furthermore, the improving smiles program engenders customer loyalty (to the brand), facilitating customer retention.

The main drawback, for an individual dentist, would be that 1300 Smiles clinics have fairly standardized pricing, and I suspect this is company policy, although I haven’t confirmed this. I know for a fact there is some flexibility, because a quick ring around turned up slight differences in pricing. However, the Improving Smiles program requires a degree of standardized pricing for basic services, at least.

The truth is that dentists who are experiencing high demand don’t need the 1300 Smiles brand, but the company can manage a practice, without lending its brand.

Correction: I previously incorrectly stated that 1300 Smiles manages LifeCare Dental practices in Western Australia. This is no longer the case, as this arrangement has ceased. I apologise unreservedly for the error. Fortunately, it doesn't change the thesis.

Why would a customer visit 1300 Smiles?

In the relatively rare event that a practice is sufficiently awesome to win the approval of the acquisitions team and the MD, 1300 Smiles might acquire an existing customer base.

More generally, North Queenslanders visit 1300 Smiles because they recognise the brand. Dr Holmes claims that securing the naming rights for the 1300 Smiles Stadium, home to the North Queensland Cowboys, was one of the better decisions he has made in his life. The better that team does, the more valuable the sponsorship will be. Let’s thank our lucky stars Dr Holmes doesn’t support Cronulla!

On a more serious note, the company does offer very competitive rates for a basic check-up, as well as discounts for Improving Smiles members and interest free finance for more expensive operations.

The Improving Smiles program itself certainly encourages repeat visits. The program costs $15 a fortnight and includes 2 checkups, 2 cleans, 2 fluoride treatments and 2 X-Rays, each year. I haven’t been able to find a better deal, and I'd probably put my children on it, if I had children.

The beauty of the 1300 Smiles Limited business model

The company’s intangible brand value accrues to the practices it controls, whether as an owner or a manager. As this brand grows, so too does the value it brings to new practices. As a consequence, the company becomes more attractive to dentists, making it easier to grow the brand.

As the network of dentists supplied by 1300 Smiles grows, so too do the potential economies of scale. This allows 1300 Smiles dentists to compete on price more effectively, making the company more attractive to dentists. In turn, this makes it easier to grow the network.

As the network grows, the utility and durability of the Improving Smiles program increases, because the risk that members will move to a location that does not have a 1300 Smiles dentist decreases. Once there are multiple 1300 Smiles dentists in every city of Australia, the chances that people will leave the Improving Smiles program are much lower. The program also encourages loyalty to the 1300 Smiles brand, rather than an individual dentist.

In short, 1300 Smiles is widening its moat as it grows.

The regulatory environment for dentistry

In December 2012 the Federal Government closed the Chronic Dental Disease Scheme (CDDS) in a mean-spirited attempt to produce a budgetary surplus. The CDDS was the easiest way for people who cannot afford dental care to receive dental care, and had grown to represent 20% of the Over-the-Counter (OTC) revenue billed by dentists in Australia.

1300 Smiles has struck a partnership with the Queensland State government to help reduce public dental care waiting lists. The Child Dental Benefits Schedule (CDBS) commenced on 1 January 2014. The program is means tested and could provide basic dental services to around 3.4 million children aged 2-17 years. The entitlement is capped at $1000 per child, every two years.

I don’t think that these measures will go anywhere near making up for the closure of the CDDS. The resulting reduction of revenue to practices will result in increasing competition, quite likely via reduction in prices. This is already evident in the market, although I’m confident 1300 Smiles practices are run sufficiently well, that operating costs are likely to be lower than at most comparable independent practices.

Nevertheless, relatively high operating leverage means that lower prices have a significant impact on the bottom line. This shows in the operating cashflow. The operating cashflow for the 2^nd half of 2013 was less than half the operating cashflow of the 1^st half. The 1^st half was a particularly good one due to the rush of patients anxious to charge the CDDS before it closed. The 2nd half as the first half without the CDDS.

Even assuming an improvement in 2014, it’s quite possible that operating cashflow could be lower than $3 million. If it is, that would imply the company is trading at a minimum of 24 times cashflow. Given depreciation was $2 million last year, the NPAT figure for FY 2014 could be as low as $4 million, putting the company on a P/E ratio of 37.5. In my opinion, this is more than the market could bear. In this scenario, the stock could fall to around $4.

Regardless of the stock price, investors should be aware that the company was able to grow cashflow from $6.2 million in 2011 to $9.6 million in 2012. Where it not for the closure of the CDDS, it would have been reasonable to expect cashflow of around $12 million in 2013. Only if cashflow has dropped to around $2.5 million (or thereabouts), should investors question whether this business will rebound. However, I don't think cashflow will come back as quickly as it was growing previously.

Discounted Cashflow Valuation of 1300 Smiles Limited

I’ve chosen to value 1300 Smiles in a way that is somewhat contentious. Generally speaking, free cash flow should be used, with allowance made for capital expenditure. However, because the company has a cash kitty that is more than adequate to cover necessary capital expenditure, I’m going to use operating cashflow, and not adjust for the cash. I believe this is appropriate as it treats the $8 million will be used for acquisitions, where appropriate, and to cover any capital expenditure that is not easily covered by cashflow at the time. The company can also be trusted to take on a couple of million worth of debt, if needed for an acquisition. 1300 Smiles pays 40%-80% of earnings as dividend, so it is reasonably safe to assume the cash kitty will in the absence of acquisitions. I will therefore use an operating cashflow of $6 million for 2014.

I’ve chosen a 15% growth rate until 2020, with a 10% growth rate thereafter. Obviously, this is necessarily an estimate of what I believe is approximately achievable. I’ve chosen a growth rate of 10% from 2021 – 2023, to reflect the fact that it will be harder for the company to grow once it get a bit larger. It's worth noting I intend to hold 1300 Smiles shares indefinitely, so the 10 year timeframe is somewhat arbitrary.

As you can see I get an indicative buy price of $5.88. This is the price at which I would consider buying (more) shares if the cashflow for 2014 is $6 million. However, as everybody knows, I added 1300 Smiles to the Hypothetical Ethical Share Portfolio at $6.50, a substantial premium to my buy price. I have done this because 1300 Smiles is an extremely ethical company, and if I have to achieve a return slightly below my target return in order to be a shareholder, that is something I am willing to do. There is also low downside risk to the company as long as Dr Daryl Holmes remains fit and healthy and in control. Thus, you can think of it as a 10% “ethics and leadership premium.”

How I’m preparing for the 1300 Smiles Half Year Results

Basically, if the cashflow is around $3.1 million, I’d probably buy shares under $5.90. However, if the cashflow is around $2.6 million, I would only pay about $5 per share. If the cashflow is closer to $4 million, I’d consider paying today’s price of $6.85, but would be more interested at around $6.50. I’m glad that the ethical portfolio bought shares at $6.50, because there is no guarantee that the share price will fall. However, I really hope that the share price does fall, as I believe there is a substantial margin of safety in the fact that this company can grow for more than 10 years. It is conservatively managed in the interests of all shareholders. What more could you want for a long term holding?

A pleasant aftertaste

At the end of the day, there's more to life than money. Equally true; you have to put your capital somewhere. If you give your money to a big bank, they will undoubtedly lend it to a mining company that will spend it on destroying the environment for future generations, or a pokies company that preys on addicts, leaving their children helpless, disadvantaged and more likely to develop their own addictions in the future.

Many dentists and staff at 1300 Smiles volunteer their time to travel to Papua New Guinea and work on board the Youth With A Mission Medical (YWAM) Ship in remote areas, performing much-needed dental work for the people of PNG. In October 2013 1300 Smiles was chosen (with YWAM) as a recipient of a Special Recognition Award from the Edward B. Shils Entrepreneurial Fund, which is a non-profit organization dedicated to innovative leadership in health care. Dr Daryl Holmes describes working with YWAM as "one of the most gratifying, worthwhile & rewarding experiences - personally, professionally & corporately - in my 26 years as a dentist & in business."

When you die, you can't take your money with you.

The Author owns shares in 1300 Smiles. Nothing on this website is advice, ever. This post is for entertainment (and for my own reference!)

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