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OPINION

Cash-rich bargain buy

Cash-rich bargain buy
July 6, 2016
Cash-rich bargain buy

I must admit some history here as I have been following the company ever since it started winding down its investment portfolio and returning cash to shareholders, something I have been capitalising on, having initiated coverage at 54.5p ('Capital returns', 11 Feb 2011). These capital returns have all been made through tender offers pitched at net asset value (NAV) per share: a buyback of 17.4 per cent of the share capital at 84p in December 2012; a buyback of 17.2 per cent of the share capital at 90p in July 2013; a buyback of 22.5 per cent of the share capital at 95p in May 2014; and a buyback of 28.7 per cent of the share capital at 96p in December 2015. This means that if you bought 10,000 shares at 54.5p when I initiated coverage, you will still retain a holding of 3,778 shares, worth £2,172, with a NAV of £3,589 by my estimates (see below), and have received total cash proceeds of £5,660. That cash return is more than the initial investment.

 

Anomalously priced

The reason why I feel LMS shares are extremely undervalued right now is because investors have failed to react to the precipitous fall in sterling since the EU Referendum unlike other companies I follow with heavy US dollar exposure: litigation investment companies Juridica (JIL) and Burford (BUR), both of which I reiterated my buy stance on recently.

This exposure to the greenback is important because at the end of the 2015 financial year, and also at the end of the first quarter, LMS held around 69 per cent of its assets in US dollar-denominated investments. The cross rate was £1:$1.474 on 31 December 2015, £1:$1.436 at the end of March 2016, and £1:331 on 30 June 2016. In the past few days sterling has weakened even further and is now trading below £1:US$1.31 and falling by the day. The point being that sterling has declined by almost 9 per cent since LMS issued a first-quarter update which revealed a NAV of £92.1m. That equated to 89p a share at the time based on an issued share capital of 103.584m shares.

By my calculations, at the end of the first quarter, £29.6m of the portfolio was invested in UK-denominated assets and a further £62.8m was in US assets. This means that the sterling value of those US assets has risen by £6m in the past three months using the latest spot rate all things being equal. It's actually more because the company holds 819,000 shares in New York Stock Exchange-quoted Weatherford International (US:WFT), a global diversified upstream oilfield service group. These were worth £3.2m at the end of March 2016, but mark the holding to market value and it's now worth £3.6m. In other words, I believe that before adjusting for fluctuations in the valuations of portfolio investments, the impact of the currency movements adds 5.8p a share to the March 2016 NAV to give a spot NAV of almost 95p a share. This means that LMS shares are priced on a 39 per cent discount to my estimate of NAV.

Furthermore, we already know that the company held net funds of around £15m at the end of May after factoring in the proceeds from disposals already announced. Add to that the liquid stake in Weatherford International and 18p a share of the current share price of 57.5p is, in effect, cash. This means that investments which I estimate are now worth 77p a share are being attributed a value of only 39.5p a share in the current share price. That's half their book value!

That's an incredibly deep discount and one that implies LMS's board has no chance of selling any of its remaining investments anywhere near book value. Frankly, that's absurd because the company has only taken a loss on one direct investment during the whole realisations process, and in some cases divested holdings as well in excess of their carrying value. The stake in Weatherford aside, the balance of the portfolio is now held pretty evenly in funds and direct unquoted investments. These investments are mainly in technology, property and consumer-focused sectors.

 

Hidden in the detail

It's also worth looking at LMS's latest annual report on page 68, which highlights the valuation criteria applied to value unquoted securities that had a carrying value of £46m at the end of 2015. Namely, they are valued using the most appropriate valuation technique such as the price of recent investment, an earnings-based approach, or a discounted cash flow approach.

In most cases, the valuation method uses inputs based on comparable quoted companies for which the key unobservable inputs are: cash profit multiples in the range of five to nine times dependent on the business of each individual company, its performance and the sector in which it operates; revenue multiples in the range 0.5–1.5 times, dependent on attributes at individual investment level; and then discounts applied ranging from 10 per cent to 30 per cent to reflect the illiquidity of unquoted companies compared to similar quoted companies. This conservative investment approach helps to explain why LMS's investment advisers have only recorded one loss on a divestment since the whole divestment process commenced.

The other point worth noting and which is spelt out in note 16 on page 66 of the 2015 annual report is that LMS doesn't hedge its currency exposure. That's great news because with over two-thirds of the portfolio in US dollars the company is set to benefit from a very strong currency tailwind if the greenback continues to strengthen against sterling as seems likely. Some currency strategists are predicting the exchange rate could fall to £1:US$1.20 by the end of the year. All things being equal, that would increase LMS's NAV to about 100p a share.

 

Hefty cash returns expected

My final point is that it's only reasonable to expect LMS to make another hefty cash return later this year through a tender offer pitched at NAV, a factor that is simply not being reflected in the depressed share price. LMS has uncalled commitments to funds it has invested of only £4.1m, or less than a quarter of the value of its liquid assets (cash and the stake in Weatherford), so already has excess capital to return.

Moreover, with the company due to report half-year results sometime between the end of this month and early August, I feel that buying the shares now ahead of news of an uplift in NAV is a very sensible move. In effect, you are buying into the investment portfolio of quoted securities and funds at only 50 per cent of their current book value, according to my calculations. In my book, that smacks of value.

On a bid-offer spread of 56p to 57.5p, I rate LMS shares a bargain buy.