Wednesday, December 2, 2015

Brammer Plc -- Distributor of MRO components

This company is the leading provider of MRO components to industrial companies in Europe. The business model is, I think, well known: it provides suppliers a direct route to market and offers customers a single interface for accessing vast choice of products. It matches the many to many in a hub-and-spoke arrangement. Market share gains enhance the network effect and thereby entrench the leader's competitive advantage. And so on, I won't belabor the point.





Brammer has been built by acquisition so it is worth taking note of whether it has created or destroyed value as it buys specialist distributors:


The conservative answer is that its acquisitions have thus far been value-neutral:


So one might value Brammer at 2.7x its net operating assets, thereby giving it no credit for growth: 

2.7 x 150 = 410; less 61 in net debt = 348 = 269p/share. This target approximates 11.5x run rate FCF.

Brammer's share price has fallen away because of its exposure to the Nordic area, the weak Euro relative to the Pound, etc. If these things correct themselves in two years then the path to a total return of 95% or so -- 80% from capital appreciation, 14% from dividends -- should be reasonably straightforward.

If not, MRO distributors tend to be cash generative in the downswing of a cycle as they shed working capital. A stylized illustration of that principle as applied to Brammer may look something like this:

  
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Addendum Dec 3, 2015

Commenters below the line have expressed reservations about Brammer that I'll address in more detail here. The reservations raised thus far fall into the following categories:

1. It does not compound value / acquisitions are dilutive / there's no operating leverage.

These are historical questions and this is the long term record. 


Let's say that one bought a share of Brammer in 2004 at 6x underlying earnings. (I'll turn to the exceptional items further down). These are the returns that one would have received:


In and out at the same multiple returns 15%. One can infer, roughly speaking, that the way to have lost money would have been to either pay a higher multiple or, worse, to have applied a higher multiple on peak earnings.

My argument: (a) It is not likely that this is peak earnings per share. (b) It is not likely that 6x earnings is as high a multiple as we are likely to see over the next 2, 5, or 10 years. 


2. It does not convert earnings into cash

This is also a historical question and, again, the long-term record is as follows

 


3. What about all those XO items?

The XO items are acquisitions related. Therefore I treat them as CapEx items as follows:


Again, the XO items have not disappeared and are not being ignored. They have been reclassified in order to make things easier to understand. Like this, for example:



Lever it up (see below) and the marginal return on invested equity is >20%.

4. It doesn't manage its balance sheet well



 
Prior to 2007 it had no equity to speak of. Since then it has effectively had a policy of using a ~ 60:40 Debt:Equity ratio  in order to generate 20% returns on equity.

5. There is no downside protection

In case of a cyclical (rather than secular) downturn, I suppose. 


We've had one major cyclical downturn in the last 10 years and working capital reversals came through as the business model would predict.

6Potential future threat of online distribution

This is the most important issue, in my view, and there are no definitive answers. What I can say is that the business most like Brammer that I know of -- Fabory -- with similar exposure to explosive growth in Eastern Europe, was acquired by Grainger at a multiple of 1x sales in 2011. 

So the question becomes, if Brammer is unable to develop its own online distribution capability, would it be cheaper to replicate its 1 million item stock list, its dozens or well-placed distribution centers, and its list of tens of thousands of customers? Or would it be cheaper to buy it at, say, 0.5x sales? I think the latter.

That's all I've got for the moment. 

Disclosure: No position (yet). 

22 comments:

  1. Just playing devil's advocate here, and I have no dog in this fight and have only quickly scanned the figures on this one - but a couple of thoughts:

    Where's the operating leverage? From 14-15 we get a jump in revenue of £70M and even if we forget the amortisation of intangibles and acquisition related costs, you still have a £11-12M odd drop in operating profit, a touch greater than the 2.1% they put down to currency. But sure, these things take time to bed in. Given the already slim margins, a tiny drop in revenue and you'll be looking at a loss making company no matter how many mentions of "underlying" they lob in there (25 in the last prelims for the record)

    A ROIC of 26% would be fantastic and I'd be interested to know how that compares to a Fastenal but it seems that figure leaves a lot of reality out. They're carrying a whole bunch of goodwill and intangibles, presumably if they created from the ground up what they bought it would have cost something - more, I assume since they're responsible stewards of capital - shouldn't we account for that? If you want to replace their PPE, gross tells you it seems to have cost double what it's carried for but perhaps they paid a far higher price for that stuff than they'd be able to get hold of it for today? As for the hidden red-headed stepchild, operating leases - even if you just capitalise them and forget about the rest of it, it kind of suggests 40 for fixed assets is lowballing it somewhat. I think in reality you'd be lucky to get to a double digit ROIC with this thing. It still has upside I'd say but £400M EV for such a low margin biz seems high to me.

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    1. 1. This is akin to a supermarket for MRO components so the question for an investor is, which is better, more defensible? High margins, low turnover? Or low margins, high turnover?

      2. Ditto with operating leverage: would you rather have margin compression in a downcyle or working capital reduction?

      3. Still, there is business development spending in the SG&A line and this is still a small company so "true" magins a likely higher than is evident by glancing at the income statement (i gove no credit for this)

      4. "stewards of capital" etc: I have broken out operating expenditures from acquisition-related expenditures and investments. I have conceded that acquisitions are not (have not been) value-enhancing. I have therefore not attached a growth multiple on the business. It follows that ROICs are iirrelevant to the investment case (except insofar as it illustrates how the business works: i.e. low margin, high turnover. (With capitalized leases the ROIC is 13%)

      5. at 150p the question is: is a 15% FCF yield good, bad, or indifferent for this company? I'm saying that it's better than good.

      6. Fastenal is somewhat unique and a bit of an outlier. A better set of comparables, in my view, includes Grainger, MSCI, Anixter, WESCO, Wolseley etc

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  2. Hi Red,

    Taking macro headwinds aside , I can see a great opportunity for consolidation in the MRO market for a company with good M&A skills.

    The problem as the first anonymous mentions these acquisitions never seems to translate in higher operating leverage, their 8% ebita margin seems to be a chimera.

    Additionally I think they should provide more information

    1)They should provide more on information on their distribution channels: online vs stores vs insite.

    2) The should provide like for like sales on stores, insites and key accounts instead of just sales growth.

    Don´t you consider that its Tools and General maintenance (more commoditize I would think) segment make them more exposed to online distributor competition (Grainger seems to have chosen this way to grow in Europe) ? . Other competitors seem to be expanding to more adding value solutions- engineering- or to focus on OEM distribution.

    In my opinion is not so good business or not so well managed but it can be a good target for a US company with a good online business and/or wider range of private label segments.



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  3. The analysis is too static in my opinion.

    Why is it that the company has grown revenues from £380m in FY07 to £715m in FY15e but EPS has declined from 20.8p in FY07 to 15.5p FY15e? In fact, since EPS peaking at 25.3 in FY08, it has never recovered to that level and will likely not reach that level until FY19 (assuming no recession). This compares to decent compounding delivered by their US peers.

    The reason, not mentioned in the article, is the woefully inappropriate capital structure and dividend policy.

    You cannot run a low margin, capital intensive, cyclical business with a 50% dividend payout ratio and an aggressive M&A strategy using over 2x EBITDA. Its madness, plain and simple.

    Hence, equity issuances are common (every 2 years). This lack of financial headroom forces them to raise equity during the trough of recessions (e.g. 09) which is highly dilutive and hence the lacklustre EPS performance. Luckily they raised a big chunk of money in FY14 otherwise they would have repeated this performance during the current industrial downturn (and they may yet do so if it is protracted).

    Note, 2x EBITDA leverage understates their leverage due to their capital intensity. They have 5% EBITDA margins (less during bad times) but 1.5% capital intensity i.e. 30% of EBITDA needs to be reinvested in the business as a real cash expense. Lets compare their US peers:

    Brammer: EBITDA margin 5% - capital intensity 1.5% = cashflow margin 3.5%

    WW Grainger: EBITDA margin 15% - capital intensity 3% = cashflow margin 12%

    Fastenal: EBITDA margin 23.5% - capital intensity 3.5% capital intensity = cashflow margin 20%

    Therefore their US peers have 12% and 20% cashflow margins versus only 3.5% at Brammer. The US peers are way better positioned to with stand negative macro environments. And yet Fastenal operates with no net debt and WW Grainger is 1x EBITDA, compared to 2x Brammer (and that is understated due to their smaller EBITDA to cashflow conversion). And despite this, Brammer has the highest dividend payout ratio. This makes no sense.

    Brammer is cheap but its hard to buy it with any downside protection unless you buy it during a downturn and straight after an equity raise and play the recovery. Its a business I want to own. I wish management would learn their lesson, look at the shareholder returns generated with a clean balance sheet, move the business into that direction and start compounding for real. Then you could own them forever. That would require explaining the transition to ignorant investors who want "efficient" balance sheet leverage, want to maintain the dividend and want the M&A to continue. So its unlikely to happen. As it stands, timing an investment in Brammer will as important as the business analysis.





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  4. Thanks for your inputs, gents. I should have anticipated some push back on this name. I'll add something more -- addressing your points -- to the main body of the post later today.

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  5. I've added text and pictures to further explain my perspective on this company and the valuation of its shares

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  6. Thanks for response to my critique. Unfortunately your answer to my question is based on flawed assumptions. Lets break down the IRR into its two components: 1) earnings growth and rating and 2) dividend yield

    EARNINGS GROWTH

    You have picked very convenient start and end points which produce a decent EPS CAGR. This goes back to my initial point: "timing an investment in Brammer will be as important as the business analysis". It is convenient because 2004 is emerging a trough of the cycle and 2014 is their peak of the current cycle.

    2004-2014: Your calculations show an EPS CAGR of +7.2% (ok but still below the US peers).

    2004-2015: why did you cut off 2015? We basically already have that result and it will be closer to 15-16p EPS. That CAGR is reduced to 3.2%, starting to look less rosy and even worse if they have to do an equity issue next year

    2007-2014: Why not try to academically compare apples to apples? 2007 was peak earnings prior to the recession. Similarly, 2014 has been the industrial cycle peak post the recession. That earnings CAGR is +0.7% (where is the peak to peak and trough to trough compounding?)

    So you have proven my point exactly. If you want a decent EPS CAGR, ideally invest in Brammer during a recession and even better after an equity raise. And then ideally exit at the top of the cycle.

    DIVIDENDS

    Is your historical calculation repeatable? I think no. 2004-2005 payout was 30-35% which allowed flexibility to increase the dividend. The 2014 payout ratio (on peak earnings) was 45.5%. In fact the 2015 payout ratio (assuming dividends are held flat) will be 65%. This does not leave much flexibility for the same sort of dividend performance we have seen in the past. Again, this echoes my initial point. Brammer needs a lower dividend payout if they are to execute their M&A and growths strategy and not be forced into dilutive equity raisings.

    So my critique remains: lack of compounding + cyclical + leverage + repeated equity raisings = scares me off. You may get lucky as right now is obviously closer to the trough than a peak and the share could easily do a quick double if the industrial environment improves. But if there is a negative turn in the macro.........good luck. I don't like taking bets on this.

    (NB: yes they had WC inflow in 09, they also did a crazily dilutive equity raise)
    (NB: yes there is downside protection from bankruptcy, im talking about downside protection on my capital invested)

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  7. I appreciate the detailed feedback

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  8. 2015 EPS -27% so through the cycle CAGR becomes less attractive as stated in my commentary. The dividend has been kept flat which puts it at a 71% payout ratio and unless there is a very fast recovery in the business, its unlikely they'll raise the dividend for a couple of years at least (they can't afford it while spending on growth and M&A). They should cut it but they'll issue equity before cutting the dividend. They've gone into cash preservation mode due to elevated leverage (2.4x vs 1.5x target and personally I think leverage is understated due to low cash conversion). So my concern remains that the environment worsens and they issue a boat load of equity at depressed prices like they do every cycle (this time they got lucky with the 2014 placement). May be they'll do something great with working capital in 2016.

    Either way, the share price was +33% from your recommendations and +20% even after today's drop. There was a lot of negativity priced in as everyone turned bearish industrials. Congrats on the pick and the timing of it!

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  9. PS this would be a great business with the right capital structure / capital allocation (see the US distributors and how they've compounded). I'm still hoping to be an owner at some point

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    1. Good commentary Alex. Curious to know what you think the value is -- even if it has problems, the buying decision should be driven by price relative to value.

      Also would like to know if you post your ideas anywhere. Good analysis.

      Thanks

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  10. What's your favourite current idea?

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  11. Nibbbled a bit. (Covenant + Brexit) vs (Inventory reduction + currency). Need to think through whether I want more UK exposure than I already have

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  12. See my comments above. The capital structure + dividend + M&A did not make sense and left them vulnerable to any downturn. Todays -50% move is what happens when things then do go bad. Dividend will be cut, equity raise will likely dilute shareholders, divi chases will flee the stock. Now is the time to watch this space.....

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    1. This will be interesting. If they want to get back to a reasonable leverage scenario (which in my opinion is still too high), they'll have to raise £40m of capital. At current prices, that's 50% of market cap.

      That's similar to what they raised in 2009, slightly more than 2011 and less than what they raised in 2014. Looks like the right ball park.

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    2. The CEO should be fired first.

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    3. He's been CEO since 1998 and investors have allowed him to run a terrible balance sheet and unsustainable capital allocation policy since early 00s. He should resign only if investors finally accept that a reset is required. Run this business at less than 1x leverage. Ideally net cash and stop these crazy dilutions every 5 years.

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    4. Finally!! New CEO happy to see someone taking accountability and big shareholder assuming their responsability and now? Big bath and raise new equity?

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  13. I'm not usually this good at predicting things! I missed the short so being right is slightly painful. The old incompetent CEO got fired. They are finally doing a wipe the slate clean equity issue rather than a patch up assuming they use the full £100m that Investec has underwritten (hopefully). They've slightly reduced the medium term debt structure to 1.0-1.5x vs 1.5x previously. Still too high in my opinion given their margin levels. The business is a mess but hopefully a new management team will clear it up over 1-2 years.

    Not sure how many equity investors will want to double up their position in the rights issue. Will be done at a massive discount. So watch this space.

    Apologies for the blatant self promotion. Some have asked whether I write about ideas. I have started - not sure how often I will post. But my blog is https://investingideasonly.wordpress.com/

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  14. Wow - I did not expect a PE bid on Brammer, especially not at a 60% premium when management was against the wall with a massive rights issue looming. What a year the stock has had.

    On the one hand its exactly what Brammer needs. The new team needs to be left to aggressively cut SKUs, withdraw from unprofitable business and rigth size the companies cost structure. And it can do this much better away from the public markets where the banks get spooked at every quarterly profit fall.

    But it also needs a cleaner balance sheet and access to capital to invest into the business. Brammer is a collection of disparate distribution businesses in disarray. It needs to invest in a cohesive operating structure. PE putting leverage on the balance sheet isnt going to be helpful.

    Will be interesting on what shape this comes back to the market in 3-5 years time.

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