Update No. 127 – 25/08/13

Next week is the final week of FY2013 reporting season. After commencing the season with 18 holdings, we have had 7 companies due to report in the final week, 2 that report out of sequence with the Australian financial year and 9 that have reported.

We had a few reports this week, most met or exceeded expectations. We bought a little more of one of the reportees this week, and completely exited another.

It is my longstanding habit to avoid discussing holdings until we exit them. Being we have exited a position I will discuss the holdings and the reason for purchasing and exiting.

Our sale this week was Transpacific Industries (TPI). When I purchased, I had specifically set out to add a couple of larger capitalisation stocks to our portfolio. I did this as a means of increasing the average liquidity of our holdings. As the proportion of external funds increases, I obviously have to consider the possibility (though we haven’t faced it yet) of someone wishing to redeem a holding of decent size in proportion to the fund’s size.

I managed to find a number of companies of decent size and liquidity that had what I determined to possess pretty good risk/reward prospects. Interestingly, despite their larger and more liquid nature, I actually considered these holdings a good deal riskier than some of our smaller and less liquid holdings.

In any case, the investment theory here was one of de-leveraging.

But first I’ll go back to the beginning. TPI destroyed shareholder value through the GFC in such a powerful way that if there was a ‘value destruction’ Olympics, they would have been a strong competitor. Over the last 5 financial years, they have made losses totalling nearly $700m, primarily from writing down the assets they overpaid for (mostly with huge sums of debt) in the boom times preceding the GFC. They have publicly done 2 major equity raisings since then and have committed to rapidly paying down the debt as a first priority. As a point of fact, they have mostly done an admirable job reducing debt. They have cut CAPEX back to just cover ‘stay-in-business’ CAPEX, and used their not unimpressive operational cash flows to pay down the debt.

Then in the report released today, well, the efforts were not sufficient to satisfy me. They have returned to growth CAPEX, spending $10.6m more than the depreciation charge on new plant and equipment. Add to this, the reduction in debt from FY2012 to FY2013 was only $75m and I don’t know if they’re pushing the debt reduction as hard as I was expecting.

In any case, the deleveraging play is supposed to work as follows. For very highly leveraged companies with sufficient cash-flow (and the co-operation of lenders) to repay overly leveraged balance sheets, NPAT/EPS growth can be unleashed very rapidly, which can lead to excellent gains, which obviously is what the time and effort I spend allocating capital all comes down to in the end. The first thing about highly leveraged companies is they tend to pay usurious rates to their lenders. Billabong have recently found themselves in such a situation:

“an initial interest rate of 35 percent on convertible debt that Billabong will issue to the Altamont group, along with a termination fee of A$65 million”

Now TPI aren’t being screwed quite that hard by their lender, but in reading their 4E, they are paying about 10.7% p.a. interest (Interest charge of $116.6m on a debt that averaged about $1.09b in FY13). I know this is high because I have a line-of-credit available to me for about 5% p.a. (you never know when a really special opportunity will present…).

The point of this is that a deleveraging often works two-fold. Firstly, the company with a billion dollar debt and 10.7% to pay on that interest frees up $10.7 (edit – this should have said $107m) million that instantly appears in the profits. Furthermore, as the level of borrowings fall, rates can often be renegotiated, which further augments profit. If TPI could get that rate down to say 9%, more than $17m in extra profit would appear in the NPAT line of the report. For a company with underlying earnings in the $50 – 60m range, these are large improvements. Furthermore, I suspected the business is due for a pretty impressive cyclical upswing. Such situations can potentially create what Charlie Munger refers to as ‘Lollapalooza effects’ where a series of events all acting in one direction can create an extraordinary result.

It is entirely possible, even probable that just such an event will still occur. TPI have in the last month sold a business that will net them over $200m, an $85m one-off gain and what they claim is a $12m annual interest reduction, so possibly I just came a year early to the party. But based on my general dissatisfaction with the speed at which the deleveraging has occurred, I will watch the next stage from the sidelines.

After netting off ‘frictional costs’, our ‘Internal Rate of Return’ on this holding was over 27%, so we did very well out of the purchase. As I point out, there is a very good chance that the ongoing holders will continue to do very well too, for I do not think the original premise incorrect, but feel instead that the reward is not worth the fact that I feel the need to check and re-check the every report and mentally model a variety of what-if’s that a good business with minimal debt doesn’t cause me to do nearly so often. Put simply, I have changed my mind on whether the potential reward is worth the risk.

We made a new record high this week and our lead over the market since inception is also at an all-time high, and we have bested the market for 5 consecutive weeks for the first time this week. However, after a rise exceeding 10% in less than two months, it wouldn’t surprise me to see a little flat patch through September, but then forecasting market movements has never been my strong suit.

As has become my habit, I will report the ‘weighted average’ portfolio metrics next week, so that you can make a reasonably informed assessment of where the performance over the last 6 months has come from (re-rating, or improving business performance) – Tony Hansen 25/08/13

EGP Fund No. 1 Pty Ltd. Up by 10.12%, leading the benchmark by 2.72% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 50.40%, leading the benchmark by 32.36% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}