Pushing the edge of credulity

One of my biggest investing edges, I think, is the fact that I come from a working class background. It has also been a drawback more than once, but you have to make your weaknesses work for you to succeed in investing.

Fear not, this is not a ‘plebeian kid makes good‘ cliche where I learn the value of a dollar and that hard work brings honest rewards and how my ancestors used to walk 40 miles to school in the pouring rain after waking up for school at 11pm the night before to feed the 17 dogs (“you could have as many dogs as you want back in them days”) and ride their pushbike instead of kids nowadays who “sit on their bloody phone all day”.

I’m quite different to the rest of my family but one thing I did take away was a thoroughly working class mindset. Which is to say that I think, and at times talk, like a 50 year old tradesperson.

What’s that got to do with the price of tea in China?

One of the ways I like to use this edge is to think about an investment in a practical sense. By which I mean, I imagine that if I explained a company’s business model to a bricklayer or plumber and they said ‘that’s fucked,’ that is a sure sign of a weak point that I need to zero in on. Maybe it’s an unethical or useless business, maybe it’s odd…or just maybe, they called it right and I should avoid it. I have three scenarios to illustrate:

Scenario 1: A Thorn analogue

You may have had a little taste of this thought process in previous posts about Thorn Group Ltd (ASX: TGA) when I thought out loud about the possible customers of this company. For the record I believe that customer demand is fairly reliable; low-income earners buying essentials for the most part. But it’s not inconceivable for a company like Thorn to look something like this instead:

Lending money at very high rates to the dodgiest and poorest borrowers in society so they can buy Xboxes and sound systems. 

I beg your pardon?  Or should that be: “You’ve got fucking rocks in your head, mate.”

Scenario 2: Estia

I came across an absolute cracker a while ago in the aged care sector, where companies like Estia Health Ltd (ASX: EHE) were obviously using Refundable Accommodation Deposits (RADs) and aggressive levels of debt to fund their operations, expansions, and sometimes even dividends.

Residents sell their house, give the proceeds (the RAD) to a retirement home, and move into the home. Rent and food etc is deducted from the RAD and the RAD itself is basically treated as an interest-free loan from resident to aged care company. This means that the RAD is basically due ‘on call’ whenever the resident leaves.

Retirement home operators were using retiree (client) funds as their own money to fund an acquisition rampage and pay dividends to shareholders.

Actually, this is legal and it makes a lot of sense; it was the government’s way of injecting additional investment funds into the sector and encouraging new care facility construction to support anticipated growth in demand in the future. But it didn’t pass the test, the way that companies were spending it and stretching their balance sheet, and I didn’t invest.

Anonymous and evil short-seller findthemoat research published a number of truly outstanding pieces on Estia and (I assume) made a lot of money shorting its shares. You can discover more through the above hyperlink.

Scenario 3: Aveo Group?

I came across a third one that didn’t pass the smell test this week. Actually, it came across me – and everyone else in Australia. I’m talking about Aveo Group (ASX: AOG), of course. It’s also in the retirement business.

This company has $1.5 billion in loans from residents on its books, that appear to be similar to the RAD in structure, i.e., they are due on call (although in truth I only had time for a brief look and I am not sure). This company has also been actively trying to lift resident churn in order to benefit from high exit fees and thus improve its cash flow.

Aveo Group, a retirement village operator with an average resident age of over 80 years, is actively aiming to get 10%-12% of its residents to leave every year in order to improve its cash flows by harvesting very high exit fees from them. 

It also looks as though the company would be plunged into a dire situation if too many residents left and it couldn’t attract new ones, because it wouldn’t be able to repay their deposits.

Say what?

Rocks, heads, the whole 9 yards. Maybe you’ll hear more from me about that one in the coming days.

I own shares in Thorn Group and have no financial interest whatsoever in the other companies mentioned. This is a disclosure and not a recommendation.

Purchase #4: Probiotec Limited (ASX:PBP)

Recently I made the 4th purchase for the 10foot portfolio, Probiotec Limited (ASX: PBP), a micro-cap contract pharmaceutical manufacturer with some interesting intellectual property. Again I have tried, with mixed success, to avoid putting up a wall of text. Here are my thoughts.

Some key stats:

Market capitalisation: $20.6m at $0.39 per share

Enterprise Value: $29.4m ($8.8m debt, virtually $0 cash)

Net tangible assets: $0.46 per share, predominantly inventories, receivables, and property. Past divestments suggest a big discount will be necessary in event of a stressed sale so I have not put too much weight on this.

Price to Earnings: 38x first half profit, albeit earnings are typically weighted heavily to 2nd half

EV/EBITDA: 13x first half (ditto)

Dividends: Nominal, 0.5c (1.1% yield) at most recent half.

Why does the 10foot investor want to own a capital intensive, low-margin manufacturer of pharmaceutical goods? Good question.

The thesis:

Probiotec is cheap given estimated full year earnings. It has good visibility of revenue due to production contracts, reliable customers, a small but significant stable of own-brand products, and spare capacity which it can draw on to support growth of its own products if necessary. With the recent divestment of assets and restructuring of the business including the combination of manufacturing efforts into one facility, the company should have less capital expenditure in the future and should be able to grow margins and generate much more free cash flow to pay down debt.

Additionally, I expect Probiotec to begin growing via new manufacturing contracts, as well as growth in its weight loss product lines. The company is small enough and cheap enough that relatively modest improvement in revenue and earnings, especially in the non-manufacturing business, could deliver respectable outcomes for shareholders.

Contract manufacturing is the main game, although Branded Pharmaceuticals and Weight Management are 3-4x as profitable at the segment EBITDA level. (source: company presentation)

Growth options:

  • Contract manufacturing; management have reported several new contracts including one worth $10m in revenue (March 2016) with the first orders being delivered in Dec. There should be a big second half and several more contracts are reportedly close to finalisation (will come online in FY18).
  • Weight management; the Impromy and Celebrity slim brands are releasing new products and Impromy in particular is chasing improved distribution. With reasonable supporting evidence behind it, I think Impromy has a good shot at growing distribution. Currently in ‘over 430’ pharmacies when there are ~5000 pharmacies Austwide.
  • Intellectual property; the company recently had positive results for a clinical trial of an eczema treatment which reported clinically significant relief to patients, which the company is aiming to find a partner to commercialise. This is ideal as it does not seem to be too expensive, provides relief but not cure (ideal for a company selling medication) and has minimal downside but possible meaningful upside. Not a part of my core thesis.
  • Europe; again not a part of my core thesis, but also minimal downside (except in event of closure + writedowns on property/segment valuation). Possible upside if some products eg Impromy or eczema one can be expanded here.
  • Gold Cross brand refresh; with distribution Australia-wide I’m not expecting much growth from the Gold Cross brand. However, it is overdue for a refresh and some marketing and this could see recent modest growth continue.
You’ll probably recognise the Gold Cross brand. (source: Probiotec website, click to enlarge)

Risks

  • The usual product and sale-specific risks; production costs rising, competition (products/services are undifferentiated except for brand), product scandals or brand damage (failing quality control etc), price pressures from major customers, loss of distributors
  • Finance-specific risks; inventory/ working capital blowout, operating leverage (high fixed costs), no cash on hand and minimal free cash flow (FCF) recently, all 3 issues magnified due to debt load
  • Major partner iNova is owned by Valeant (yes, that Valeant)
  • Big blowout in receivables with $1.6m past due as of annual report last year (no figure given at HY17). A big risk is that customers go broke/ don’t pay and Probiotec effectively works for free, wearing the cost of raw materials and manufacture.
source: 2016 annual report (click to enlarge)

Valeant

OK so if you’ve been around a little while you know that Valeant is a very smelly company that some people think will go to zero. But, it also has very successful pharmacy businesses that are profitable and valuable. Probiotec has been partnered with iNova for quite a while so I think the risk of fraud or some such affecting Probiotec is quite low. It is possible that Valeant goes bankrupt and iNova collapses, but I also find that unlikely as the business is very well established and likely worth a fair amount of money. If iNova or other major customers collapsed it would be bad news for Probiotec, which has $9m in receivables.

The most likely risk I see here is that iNova gets sold off (reportedly Valeant is already looking for buyers) and there could be some sort of ‘change of control’ clause in the manufacturing contracts that could see iNova potentially exit its agreements with Probiotec. Alternatively iNova could look to bring manufacturing in-house, acquire a manufacturer, or lean on Probiotec to squeeze margins etc. I don’t think it too likely as iNova is expanding its contracts with PBP, but is something to keep an eye on.

Impromy

I feel this brand has some promise, particularly due to the strong results from the clinical trials. While it is effectively just a diet shake and meal plan (and thus undifferentiated) the harnessing of the pharmacy for measuring blood sugar levels etc should help lift customer engagement and success, and results so far (the best among a variety of competing programs) support this idea.

Management

Probiotec appears to be family-operated, with the Stringer family Messrs Wesley and Jared being the Managing Director and CFO respectively. Wes has 870,000 shares and Jared held 315,000 as of the annual report last year.  CEO Wes is a former investment banker who was with Probiotec for 14 years as COO. CFO Jared is an accountant (CPA) and has been with Probiotec since 2002, but I couldn’t find much more about him.

New Chairman Geoffrey Pearce is formerly of BWX Ltd (ASX: BWX). Recently appointed director Greg Lan (who has been buying shares aggressively) comes to Probiotec after 15 years at Aspen Pharmacare. Major shareholder and director Robyn Tedder resigned last year and I couldn’t really determine why (there was a bit of board infighting which may explain it).

Other than shareholdings which seemed a bit small (unusual for family-operated biz) and salaries which seemed a bit high (not unusual for same) I’m happy with the quality and alignment of management. I do take into account though the previously much higher price of Probiotec shares over the past 15 years so it’s quite possible their dollar value investments are much larger than the # of shares would suggest.

I’d still be looking to see execs purchasing more shares in near future. I do prefer owner/founder types when it comes to management though, and the Stringers (and previous CEO, also a Stringer) tick a lot of boxes for me.

The bottom line

In a nutshell; Probiotec is cheaper than the market realises. With visible revenue due to manufacturing contracts and own-brand sales, debt appears manageable, while good management, lower capital expenditure and revenue growth in own-brand products could potentially make it quite a strong performer. It is a higher risk investment.

On the 16th of June 2017, I purchased 1200 shares at $0.425 each, for an average price of $0.4374 after brokerage.

I’ll soon begin a quarterly review of the 10foot portfolio for the 3 months to 30 June 2017, you can enter your email in the subscription box to receive an update when it’s out.

I own shares in Probiotec Limited (ASX:PBP). This is a disclosure and not a recommendation.

A compelling bear case for Thorn Group Ltd

Via Twitter, the 10footinvestor stumbled across an interesting bear case about Thorn Group Ltd (ASX: TGA) on blogspot today. It suggests that the company will need to raise capital, and provides an interesting counterpoint to the 10foot shareholding in Thorn.

It seems to be a the blog of a ‘Mitch Dawney’ who apparently runs an activist (?) company that today made an interesting approach to AWE Limited (ASX: AWE). His posts are well written and speak for themselves:

Thorn Group (TGA) – the thorny end?

Thorn Group 2017 Annual Report

The major assertions are that the company is loading up on debt, originations are struggling, it’s inflating its headline profit, and a few other gremlins. They are thorny concerns, and fair. The gist of them, and the most compelling bear thesis for Thorn is (I quote):

“The risk is that the company becomes more leveraged by increasing corporate facilities further in an attempt to sustain the origination machine. History has shown us what happens when lenders are focused on origination revenue and lever up to satisfy sales; there is less of an equity buffer when losses from past originations eventually catch up.”

I’m fairly sanguine about some of the other concerns raised, such as the pricing caps on income, rising cost of funds, the inflation of headline profit and so on. It’s not that they are not risks – they are. Yet in my opinion the primary issues are 3 things:

  • ongoing demand for Thorn’s services (or lack, given that new leases drive profit)
  • the likelihood of increasing delinquencies
  • ability to fund ongoing business and growth

We seem to be looking at a different side of the same coin, in that (compared to him) I am under-rating the likelihood of certain risks and over-rating the likelihood of Thorn’s positive attributes.

The main goal is to ensure that, even if wrong, the 10foot portfolio suffers a minimal amount of damage on its bad investments. It is good to see a negative view on Thorn and this is something I will keep in mind. I will let you know if I change my mind on Thorn.

In other news, I received some great comments on my Henry Morgan posts, which I recommend reading if you are interested in that story. I intend to reply to the comments in a subsequent post (and will do so soon), but I have been spending my time researching another company which I recently purchased for the 10foot portfolio. You’ll be able to read about that in a week or so.

I own shares in Thorn Group. This is a disclosure and not a recommendation.

The 10footinvestor does not tweet often, but can be found @10footinvestor on Twitter for the twitterers (twits? tweople?) out there.