Anyone who has worked in finance or studied it for any length of time will be familiar with the phrase: “there is no such thing as a free lunch”. Products or services are never free even if they appear so. An investment that promises a fantastic return will always involve considerable risk. There is always a catch because you cannot get something for nothing.
Or so the theory goes.
Speaking from experience, when it comes to investing, most of the time this is true. What often appears like a great idea at first, on closer inspection turns out to be rather more mundane once the risks are fully understood. Very occasionally though, Mr Market does offer something truly special: an investment with great return potential and very little risk of capital loss – a true free lunch.
I believe the investment vehicle Better Capital is one of these rare situations1. The company’s business model is to buy distressed or bankrupt companies and invest in them in order to improve their profitability and eventually sell them on. Operated like a private equity model, there are two “cells” (“vintages” in private equity terminology) each containing different investments. I discussed the 2009 cell previously, but my focus in this post is the 2012 cell.
Before diving into the detail of this particular situation, it is important to understand some background. Better Capital is usually associated with its Chairman and Founder Jon Moulton, a man who is not shy of the public eye. Unfortunately, over the past 2-3 years, he and Better Capital, have become associated with some high profile corporate failures, most notably City Link, which was put into administration on Christmas Eve 2014 after a failed turnaround attempt. The shares themselves are off the radar of most mainstream investors and not very liquid. No surprise then that this run of bad news has led to a relentless decline in the share price from over 100p to 33p today.
What does a 33p investment in these shares get you today?
The 2012 cell owns five companies, all of which are entirely independent from each other with no cross party guarantees or liabilities. In no particular order2:
Everest – A national vendor of windows and doors. The company has been around for decades and has good brand recognition. It is a cyclical end market with 3-4 major national players, of which Safestyle is the main listed competitor and is currently performing the best. Since 2004, Everest has averaged £140m sales and a 5.6% operating profit margin, although this has been as high as 9.6%. The company was loss making in 2011 when it got into financial trouble, eventually being bought by Better Capital, under whose ownership trading has stabilised. Recently trading has been weaker as the company has lost some market share in a weak overall market. Better Capital value the company at £44.5m. This seems conservative for a business with c.£130m sales that has earned an average £6m EBITDA profit under the three years of Better Capital ownership but which in the past has done much better than this and with peers that are also significantly more profitable. The company also has next to no external debt.
Spicers OfficeTeam (SPOT) – a national distributor of office products and supplies, formed from the merger of Spicers and Office Team. Initially plagued with warehouse problems, management have got this business back on track. Last year it reported c.£300m sales and £6.6m of profit, however this was still heavily depressed by the loss making Spicers business. The traditional office supplies end market is in moderate structural decline, however there are other areas that are growing and also scope to consolidate the industry further creating efficiencies. Better Capital value SPOT at £65m. This seems reasonable in the context of a £15m budget for profits for the 2016 year which, at the last update, the company was on track to achieve.
iNTERTAIN – owner and operator of 30 bars (25 “Walkabout” bars plus 5 non-branded sites). This business has been successfully turned around by Better Capital. The combination of the closure of underperforming sites and investment into the better sites has led to a profitable and growing business. It is valued by Better Capital at £38m based on market multiples. iNTERTAIN has a net cash balance sheet.
CAV Aerospace – engineering company making specialist parts for the aerospace industry. The company was purchased by Better Capital 18 months ago, since when it has performed below expectations. Onerous legacy contracts unknowable at the time of purchase meant that management had to renegotiate terms with key customers to avoid the business failing. Fortunately this has been achieved, with the latest update indicating that the business is profitable again. Better Capital value the business on an asset value basis – the £31m valuation consists of £5m net cash, a £10m warranty claim against the previous owner plus a liquidation value for the assets. With the risk of failure having diminished, this seems reasonable for a business with c.£80m of sales and which is firmly embedded within the aerospace supply chain.
Jaeger – high street fashion retail. Better Capital have owned Jaeger for a number of years. The brand is well known and has been successful in the past. Better Capital haven’t managed to get the format quite right yet, although to be fair this has been a difficult few years for high street fashion retail. Sales are around £85m, but the company is still moderately loss making. Better Capital value it at £37m. This valuation includes a net cash position sufficient to fund the company’s turnaround plan.
How could a bunch of seemingly troubled businesses be a no-brainer investment case? The answer rests on some fairly simple maths.
Add up the above valuations of these five businesses and you get £215m, 85% above the current market capitalisation of £115m. However, the true picture is better than this because Better Capital have recently been buying back their own shares with their surplus cash. Instead of cancelling the shares as companies usually do, they have been holding them as an investment. The most recent statement from the company indicated that they had purchased 16.5% of their own shares. Adjust for this and the 85% rises to 125%.
Of course it would be naïve to assume the eventual realisation for each of the five companies equals their current valuation. But the point is there is an enormous margin of safety here. I find it very difficult to imagine a scenario in which the shares end up being worth less than the current 33p. All of the five companies are now well funded and, with the exception of Jaegar, are profitable. To be worth less than 33p, would require 3 of the 5 portfolio companies to be worth zero. The absence of any significant external debt and the largely uncorrelated nature of the risk factors affecting these businesses make this, in my view, highly unlikely.
Moreover, with the exception of iNTERTAIN, all of these companies are operating below their long-term potential. They each have longer term business plans that envision profitability significantly higher than current levels, little of which is reflected in the current valuations. It is perfectly possible that one or more will deliver on their plans, resulting in significantly higher eventual realisation prices.
It is easy to see why most people wouldn’t go near an investment like this because the assets appear troubled and the media coverage negative. But this, I believe, is exactly why the opportunity exists.
1. This is no recommendation to buy or sell any particular security
2. The following financial data is sourced from the Better Capital company reports and Companies House.