To narrow the search down, shares in my target must not only be trading on a deep discount to net asset value (NAV), but also offer an investment angle that investors have overlooked, leading them to inadvertently miscalculate the company's intrinsic value. Put simply, we are aiming to get our hands on an asset-backed firm where the risk-reward ratio is weighted heavily in our favour, but one that should provide significant share price upside as, and when, the rest of the market discovers the valuation anomaly.
With this in mind, I noted with great interest the pre-close trading statement from Walker Greenbank, the luxury interior furnishings outfit whose brands include Morrison & Co, Harlequin and Zoffany (www.walkergreenbank.com). The venerable company has been specialising in this line of business for the best part of 20 years, but the longevity of some of its brands goes back even further, with Sanderson celebrating its 150th anniversary this year.
And it has been the resilience of mid market brands such as Harlequin and Sanderson that have enabled the company to successfully trade through the economic downturn. So much so that after a tough first half last year, when pre-tax profits fell two-thirds to £0.6m in the six-month period to end July, chief executive John Sachs was able to announce in mid-December that sales trends in the second half have been gathering momentum and full-year pre-tax profits for the 12 months to the end of January 2010 would come in ahead of market estimates. This prompted analysts at Oriel Securities to upgrade their full-year pre-tax profit and EPS forecasts by 12 per cent to £2.3m and 3p, respectively, for the financial year just ended. With the shares (TIDM: WGB) trading at a mid price of 22p as of Monday morning, on a 1p bid-offer spread, the business is being rated on a modest 7.5 times earnings.
The story got even better last week after Mr Sachs revealed that strong cash generation in the second half - on the back of tighter stock control, lower capital expenditure and an improved operational performance - has enabled Walker Greenbank to cut net debt to £3.2m from £6.7m at the end of July. Lower borrowings not only significantly reduce net interest costs, but will give management scope to make significant investment in product launches to further leverage off the operational recovery.
It's worth noting, too, that after a poor first half last year when sales dipped by 11.8 per cent, comparatives this time round will be relatively easy to beat. So if the current sales momentum is maintained, there could be some very positive trading statements released by Walker Greenbank in the first half this year. And remember, this is a business that by its nature is more operationally geared than most, so modest increases in sales can have a profound impact on profits. Indeed, although house broker Arden Partners expects sales to increase by 4 per cent from £59.9m to £62.4m in the year to 31 January 2011, pre-tax profits and EPS are forecast to surge to £3m and 3.8p, respectively.
Based on these numbers, the shares are currently trading on a meagre six times earnings estimates, which is hardly testing even for the consumer cyclical sector. By comparison, on a peer-group basis, shares in rival Colefax are rated on around 13 times full-year earnings using a normalised tax charge. Moreover, we will not have to wait long for Walker Greenbank's next trading update, as its preliminary results are scheduled for release on Wednesday 14 April.
The company also looks undervalued on a price-to-book value basis, with shareholders' funds of £21.4m comfortably exceeding its market value of £13.1m. It's worth pointing out that around £8.6m of those £21.4m of net assets is invested in property and plant, split equally between freehold buildings and land and plant and equipment. Those are not the only rock-solid assets on the balance sheet, as Walker Greenbank also owns the valuable Arthur Anderson and William Morris archives of unique designs that are used to generate a significant royalty income. Both are valued at historic cost and are in the company's books at £5.8m. Or put it another way, with the shares trading so far below book value, we are in effect getting all those valuable archives and £2.5m of the freehold property assets in the price for nothing.
So with Walker Greenbank in recovery mode, sales momentum building and the business facing soft comparatives in the first half this year, we have all the ingredients in place for a share price rerating and one which could be quite sharp. Indeed, based on a forward earnings multiple of 10.5 and price-to-book value parity by this time next year, fair value for the share price is around 40p, which potentially offers 74 per cent upside to investors taking a 12-month view. The valuation may be anomalous, but I don't expect this to last and rate the shares a low risk medium-term recovery buy.
