In fact, it’s such an important part of stock picking that I dedicated a whole chapter in my book, Stock Picking for Profit, for this very reason and highlighted in case studies some of the classic recovery plays I have successfully identified in Investors Chronicle. From my experience, it’s best to concentrate on certain key characteristics that occur time and time again in these special situations to increase the likelihood of picking out the winners. One of the most important is having a management team in place with experience of successfully turning around businesses previously. Moreover, if the insiders honestly believe in the turnaround story, then expect them to put their own money into the company. That’s reason enough to look out for share buying by the directors as early signs of recovery in the business emerge. It’s also why our weekly director dealings tables are invaluable in identifying these special situations so that you can ride off the coat-tails of the insiders.
I also pay close attention to any plans for restructuring the business in order to lower the company’s cost base, realign operations and cut working capital requirements. More often than not the board will carry out a kitchen-sinking of the accounts which will lead to large write-offs initially in order to clear the decks prior to the turnaround becoming apparent. The benefit of this is that it gets all the one-off hits out of the way so that the management team can start with a clean slate.
Cash is king
As regular readers of my columns will know I always pay close attention to cash flow and cash profitability rather than simply relying on the headline numbers. With recovery plays expect a company to turn profitable at the cash profit level before a move into reported profits. It’s well worth taking note if that happens because if a company is no longer draining cash, and has at least turned cash neutral, then this alters the investment case materially. With this in mind, I always look at the working capital requirements of a business and for signs that improving stock control is boosting cash flow and the company’s net cash position.
I also pay very close attention to the notes of the company’s accounts when analysing the net debt position. Ideally, I am looking for a recovery play where where borrowings are manageable and there is substantial asset backing in place to give management enough time to turn around the business. That limits the financial risk associated with the investment. In my experience, it is far easier to create a virtuous circle whereby operating cash flow is recycled back into the business, used to pay down debt, or returned to shareholders through share buybacks and dividends, for lowly geared or cash-rich companies than for highly indebted ones.
In the retail sector, some of the companies I have successfully identified showing these specific characteristics include Moss Bros (MOSB: 105p), Walker Greenbank (WGB: 205p) and Ideal Shopping Direct (IDS: taken over), all of which subsequently produced massive share price gains. In the cases of Moss Bros and Ideal Shopping Direct the re-ratings also reflect the fact that the underlying businesses were being attributed miserly valuations after adjusting for their cash positions when I first identified their recovery potential.
Ideal scenario
The ideal scenario for a recovery play is where costs are under control and cashflow performance is improving, so any uptick in sales will have an accentuated impact on operating profits assuming of course a restructuring of the business has reduced overheads. This means a greater proportion of revenues falls straight down to the bottom line as the operational gearing effect kicks in.
This is why I try and estimate the impact of variations of sales on profits to calculate a best case scenario where revenue growth beats management’s guidance and analysts’ expectations. If there is a realistic chance of this happening then the scope for the company to enter an earnings upgrade cycle increases markedly. It also pays to avoid companies with poor cash flow performance - especially those where increases in operating profits are not being converted into improving operating cash flow. For this reason, it’s best to seek out companies that are converting a very high percentage of operating cash flow into operating profit.
It’s also well worth reading through the notes to the accounts on the company’s tax status. That’s because companies that have underperformed previously may have unutilised tax losses which can be used to wipe out the corporation tax liability on future profits. In turn, as revenues pick up and profits rise, this means earnings per share will increase faster than normal as profits recover due to absence of tax charge.
That’s an important point to note because a company showing clear signs of earnings momentum will more often than not be attributed a higher valuation by investors. This leads to an expansion of the earnings multiple the shares are rated on, so not only can you expect the share price to rise as earnings growth comes through, but also for the PE ratio to rise as well. This is far more likely to happen with cash rich or lowly geared companies. For instance, in the case of Walker Greenbank, the rerating would not have been as great if debt levels had been significantly higher at the start of the recovery four years ago, as this would have introduced far more risk to the investment and deterred investors from valuing the shares on a higher earnings multiple as the earnings momentum started to feed through.
In my opinion, the ideal recovery play is one that has clear drivers in place to enter a medium-term earnings upgrade cycle as revenue growth picks up, rather than one lasting six months or less as the boost from restructuring comes to an end. Bearing this in mind I keep a keen eye on businesses where the management team aim to exploit new markets and launch new products, and where structural changes in an industry can be turned to their advantage, to create the platform for a medium-term upgrade cycle.
All of which leads me back to general retailer Moss Bros (MOSB: 105p) which has just released a bumper set of full-year results, and one that has forced me yet again to upgrade my target price.
A chic performance
Moss Bros is a company I have been following closely for the past couple of years, having initiated coverage when the price was 39p (‘Dressed for success’, 20 February 2012). It’s worth recounting the investment case which attracted me to the company in the first place. A cash pile of £23m meant there was no financial risk and given Moss Bros generated cash profits of £5.8m in the year to January 2012, up from a hefty loss the prior year, then this was enough to fund annual maintenance capital spend of £2.1m and still leave a further £3.7m to expand the business. Investment on this scale in store refurbishments not only boosted profits, but created a virtuous circle where these incremental profits could be recycled into new store refits. For good measure, Moss Bros also had the benefit of carried-forward tax losses. And on a standard earnings basis the shares were miserly rated: strip out net cash of 25p from Moss Bros share price of 39p a couple of years ago, and the shares were priced on only eight times WH Ireland's EPS estimate of 1.6p for the 12 months to January 2013.
As the earnings recovery gathered pace, investors have been happy to pay a far higher multiple of earnings to buy into the company. That’s sensible as Moss Bros beat those expectations and actually produced EPS of 2.3p in the 2012/13 financial year, before ramping up EPS by almost half to 3.76p in the 12 months to end January 2014. In this two year period the cash pile has swelled to £28.1m, worth 28p a share, and that’s after funding a store refurbishment programme which has seen 10 per cent of the 133-strong estate of shops upgraded in the past 12 months alone, with another 28 refits planned this year. It’s paying off too as underlying sales rose by over 4 per cent in the latest 12-month trading period, and in the first eight weeks of the new financial year they are up over 7 per cent.
The company has also invested in new products to broaden its appeal such as launching a slim fit contemporary range aimed at a younger audience. A move into e-tailing is paying off too: e-commerce sales trebled last year and now account for 5 per cent of total sales. Moreover, entry into new markets overseas is clearly reaping dividends as international sales now account for 8 per cent of internet transactions.
Shareholders reaping the rewards
The massive share price gains aside, shareholders are now seeing the benefits too. In fact, with the business now making annual cash profits of £9.3m, the board have been able to adopt a progressive dividend policy, having raised the final payout eight-fold to 4.7p a share in the year to end January 2014 (ex-dividend date of 4 June). Analysts expect the total payout to be hiked even further to 5.5p a share in the current financial year, rising to 6p in fiscal 2015/16. On that basis, the prospective dividend yield is 5 per cent and net of cash the shares are priced on a historic PE ratio of 20. That may seem a punchy rating for a retailer, but with Moss Bros surpassing expectations, that doesn’t seem a high price to pay given analysts predict annual pre-tax profits will rise by two thirds from £4m last year to £6.7m over the next three financial years. I would not be surprised at all if that target is hit much sooner.
In any case, with the company being valued on around eight times cash profits to enterprise value (market capitalisation less net cash), the multiple still doesn’t look full given that the excess cash is being recycled back to shareholders.
For good measure, the technical set-up is equally promising as there is no overhead resistance at all until a major price level around 130p, dating back eight years. So with the company outperforming expectations, earnings in an upgrade cycle, and the management team having a plan in place to grow profits by investing in new initiatives and store refits, then I have no hesitation at all at maintaining a buy recommendation.
Furthermore, having identified a buying opportunity when Moss Bros’ shares were priced at 71p just before Christmas ('Dressed for retail success’, 16 December 2013), and upgraded my target price to 110p after a buoyant pre-close trading update a month later (‘A chic performance’, 14 January 2014), I now feel a target range between 120p to 130p is realistic both from a fundamental point of view and from a technical perspective too. On a bid-offer spread of 104p to 105p, I continue to rate Moss Bros shares a buy ahead of the next trading update to be released at the annual general meeting on 23 May and interim results due out on 22 September.
Please note I will be on holiday this week and my next online column will be published in the afternoon on Monday 7 April.
