Thursday, 24 December 2015

My Investment Mistakes of 2015

One of the reasons I love investing is that it is not just a battle against other intelligent, knowledgeable and committed people but a battle against yourself. Each of us have biases that prevent us from acting optimally and it is by knowing ourselves better and designing strategies to overcome these biases that we become better investors. It is in this spirit I offer, not a celebration of the 2015 successes or tips for 2016, but some of the mistakes I made this year:

Not being bold enough when the downside was negligible

On 12th August a company called Pure Wafer announced that they would return 140-145p to shareholders from an insurance payout related to a fire in the UK part of their business. The shares opened that day at 145p to buy, presumably due to generally poor market sentiment in August 2015. Given that the company still retained a profitable US trading business then it was highly unlikely the shares would be worth less than 145p. I used all of the spare cash in my dealing account to purchase shares and then turned to my spread betting account. However at this point I was not bold enough. Given that the downside was negligible I should have used all available margin to open a position however I was too cautious and only added a small amount. The shares rapidly rose to 165p that day as others realised the opportunity and following the sale of the trading business should return 188p in total to investors. The market rarely offers a free lunch but when it does you need to absolutely stuff yourself.

Thinking that buying the best companies in an industry with bad economics would protect the downside

One of the biggest investment themes of 2015 has been the rout of commodity prices and the impact on commodity producers. Although I’ve never liked commodity exposure as investment theme in itself there are certain attractions to owing oil companies. Their assets are easily analysed and assets that will be drilled or developed far in the future are often neglected in valuations giving opportunity to those with longer term investment horizons. As a contrarian investor I wanted exposure to the sector but to limit the downside should there be no medium term oil price recovery. Therefore I added shares like Ophir & Bowleven that had strategic assets and large cash holdings. Despite paying historically low prices and below cash in the case of Bowleven that didn’t stop prices falling as the oil price fell further. When a sector is seriously out of favour then everything gets sold. This maybe illogical and may be a good contrarian buy going forwards but the strategy of buying the cash rich oil companies didn’t in reality protect the downside in 2015.

Being too worried about the spread

The commodities rout has had a knock on impact into the oil services sector leaving a number of companies looking very cheap, at least on historic metrics. I’m always interested in extremely sold off shares and unlike oil exploration and production companies the service companies often have other subsidiaries unaffected by the oil price collapse. Two such companies that are on my watch list are Northbridge Industrial and Pressure Technologies. In both cases I was very close to buying, Northbridge quoted at 66p and Pressure Technologies quoted at 147p. In both cases I rejected the quote because I didn’t want to pay the full ask. Prices now are 89p for Northbridge and 192p for Pressure following trading statements or results that were not great but simply not as bad as the market feared. Sometimes it pays to pay up, especially when prices are already significantly depressed.

Failing to exit an investment going wrong quickly

On 17th March defence training specialist Pennant International reported their FY results. Although on the surface they seemed to be fairly positive a detailed reading of the figures suggested that they were struggling in a number of areas and were overly reliant on a few contracts. Since I was slow to do the full analysis the price had dropped from 98p to c.80p by the time that I had realised that things were not as rosy as they initially appeared and due (presumably to loss aversion) I didn’t sell. Today Pennant trades at 40p.

Exiting promotional shorts too soon

Nothing goes up 4-5x in a couple of months without significant amounts of ‘hot money’ being involved. Therefore when you see these sort of rises in story stocks they can make very good shorts. Particularly where there is some kind of share overhang on its way (e.g. a lockup period for a major holder ending) which will apply pressure to reverse the flow of hot money. The area that I have found most lucrative is companies that have entered into an equity swap financing deal like Amur Minerals or AFC Energy. These deals see the company raising funds by issuing shares to a company like Lanstead Capital but using that cash to enter into a swap agreement with Lanstead whereby the cash payment they receive each month depends on the share price. This leads to a strange mix of incentives. The management want the share price as high as possible but once it has risen the swap provider wants to sell as many shares as possible to fund their payments to the company and reduce the amount that they pay. Hence the spike up and the slow decline:

Amur Minerals

 AFC Energy

So what’s the mistake? In both cases having got good entry points (40p for Amur Minerals & 54p for AFC Energy) I closed the shorts far too soon (27p for Amur & 33p for AFC.) What went wrong was I started to fear the promote would push the shares higher and failed to believe my own analysis that said that the share overhang of the equity swap provider exiting would push the shares much lower and reverse the flow of hot money. Amur currently trades at 8p and AFC at 24p. It’s annoying to get the analysis right but not fully capture the resulting move.

Underestimating how foolish takeover buyers can be

In March 2015 the Australian law firm Slater & Gordon paid £640m for the legal services part of Quindell a company of which I was short. My analysis had shown that there were significant issues with the quality of Quindell's business and that without Slater & Gordon's intervention the group was likely to run out of cash. It seemed completely illogical that S&G would pay a significant premium of £640m for a business that was close to bankruptcy particularly since it would require significant debt and equity raise by S&G to fund it. As it turns out that my analysis was probably correct and Slater & Gordon have subsequent lost almost 90% of their value since the deal. What I got wrong was probably not the analysis but dismissing quite well sourced rumours that a deal had been done and then closing the short when the deal was announced. The rest of the Quindell business was of such poor quality that if I'd simply rode out the intitial deal spike I still would have made money on the short.

I’m sure I’ll make many more mistakes next year and despite these this year I made enough good decisions to generate an ok return. My aim however is not to repeat these particular ones.

Wishing you all a Happy Christmas! And may you only make new mistakes in 2016 too.

Saturday, 5 December 2015

Is Avanti Communications' equity worthless?

I originally wrote a version of this post on but thought worth re-jigging it on here to incorporate some further research and thoughts into one place.

Avanti (AVN.L) is a communications company operating satellites providing internet capacity to users who don’t have access to regular high speed internet capacity via broadband. Currently they have 4 operational satellites (ARTEMIS, HYLAS 1, HYLAS 2, HYLAS 2-B) with plans to launch 2 more in 2017 (HYLAS 3 & HYLAS 4).

Launching satellites is a capital intensive business. You spend hundreds of millions of dollars getting them into space with the expectation that they pay for themselves many times over in their c.15 year useful lifetime. The capital intensity combined with the long payback period makes Avanti a high risk investment. If the geographic areas they covered were to receive broadband access of high speed mobile internet then the demand for their services would decline rapidly or face severe pricing pressures. The investment case for Avanti very much depends on how rapidly they can sell their satellite capacity while retaining premium pricing. Any analysis of the company should focus on these factors.

They have been heavily loss making so far but promise rapid growth that will deliver profitability to the company in the future:

…management expects cash generation to grow swiftly as revenues exceed Avanti's largely fixed cost base.’ Q1 2016 Trading Statement

In order to judge their success we need to look at what are their sources of revenue. These are my understanding of the main categories of Avanti’s sales in order of declining quality:

  1. Data sales – these are really what Avanti is about selling internet data - they should be high margin and cash received under normal payment terms.
  2. Equipment sales – Avanti also provide the equipment for users to access their data services. Usually these will be paid in cash, again good quality but variable in nature.
  3. Project sales - where they are paid to do work for a client, good quality but usually non-recurring.
  4. Equipment sales where they are paid over a number of years - presumably they are intended to allow cash strapped customers to generate data sales they couldn't otherwise however these are particularly poor quality earnings since the revenue is booked in year 1 with the cash coming in much later and the risk of bad debt (of which they have had some.) Also since they are lending the money to the customers at about half of their cost of debt capital the longer the terms the worse the deal as Matthew Earl points out here:
  5. Spectrum sales - as far as I can tell these seem to be completely non-cash since there is no up-front payment to them and no accrual in the balance sheet. As Tom Winnifrith points out rather than generating cash for Avanti this ‘sale’ is costing them $13m cash over the next few years: . These sales are of such poor quality that it seems Winnifrith has written to the FRC to question it.

It would be great to be able to separate out the revenue and costs associated with data sales and equipment sales and analyse these separately but as far as I can tell Avanti have not provided these consistently. In the 2014 Annual Report they do break revenue out into $16.6m of equipment sales out of $65.6m total. They did the same in 2013 but in the 2015 Annual Report they only break out the $25.1m Spectrum ‘sales’. Also you have to read the notes to the Annual Reports to see these. They don’t seem to be broken out in the half year results or in the results RNS’s. Hence the analysis that follows excludes the non-cash sales of Spectrum Rights but assumes all other revenue is recurring.

Things were going well for Avanti until H1 2015 when revenue started to drop. (H1 2016 is estimated by doubling Q1 2016 revenue.)

This sort of drop off in revenue can mean one of two things. Either customers are using less of £AVN ’s services, or they are paying less for them. 

Not that you’d be able to see this revenue drop if you read Avanti’s management commentary. By careful choice of comparatives, last quarter vs same quarter in the previous year, and including exceptionals in the reporting period and excluding them in the comparative period they have managed to give the appearance of rapid revenue growth in a period when revenue has been dropping half on half:

Let’s look at some of the comments relating to utilization and pricing:

‘Average Fleet Utilisation was at the upper end of the 20% to 25% range during the period’ Q1 2016 Trading Statement

‘Avanti's average pricing remained stable.’ Q1 2016 Trading Statement

‘This was lower than Avanti's prevailing run rate of growth, due to a larger amount of equipment and government revenue in the previous year, which, although recurring, tends to be recognised on a non-linear basis.’ Q1 2016 Trading Statement

‘Avanti's Fleet Utilisation was within the 20% to 25% band at the end of 2015, having increased from the 10% to 15% range in the prior year.’ 2015 FY Results

Based on these comments I’ve added estimate of the utilisation to the revenue graph:
So it seems that data rates are stable but customers are paying less for £AVN’s equipment or value added services meaning that rapidly increasing utilisation is not turning into increasing revenue.

So if we are conservative and assume that Q1 2016 had very little equipment sales and was mostly data revenue what is interesting is to scale up the Q1 2016 revenue to get the maximum theoretical revenue at full utilisation as Avanti suggest we do in their 2015 annual report:

If we take 23% as ‘the upper end of the 20% to 25% range’ then based on the Q1 2016 revenue of $13.6m at the current pricing the maximum theoretical revenue of the existing satellites is $238m a year.
So how fixed are those costs? The accounts split costs into 3 categories:
1.   ‘Satellite Depreciation’ we will ignore for now as a non-cash cost.

2.   Operating Expenses do appear to be largely fixed costs running at $35m pa for the last couple of years. If anything these will increase slightly as Avanti state ‘There will be a modest increase in costs in 2016 as further investments are made in sales and marketing and ground operations ahead of the launches of HYLAS 3 and HYLAS 4.’ Annual Report 2015

3.     Cost of Sales however do not appear to be fixed as an absolute value but as a percentage of revenue of c.60%. I had expected the gross margin to increase as data sales made up a greater proportion of revenue however there is little sign of this in the numbers. Given that COS as a % of revenue are around 60% when revenue is $7m or $40m then it would seem a reasonable figure to take for COS as a percentage of $238m revenue = $143m.
So at full utilisation the current satellites will generate OCF of $238m – $143m – $35m = $60m.
However Avanti has c.$640m of debt accruing interest at 10%pa = $64m/year interest which means even at full utilisation the current satellites would generate a cash loss of $4m/year. Given these sums it is somewhat surprising that the Avanti share price reacted positively to the Q1 2016 results, although it has since fallen back to below previous levels.

Avanti have $219m of cash on hand so can manage an extended period of high negative cash flow however the majority of that cash is committed to the development and launch costs of HYLAS 3 & 4. This means that although I don’t think the committed cash should be included in a valuation it is also wrong to exclude the future potential revenue from HYLAS 3 & 4 when they are launched in 2017.
In order to work out what the impact of the valuation implied by the $13.7m Q1 revenue and 'upper end of the 20% to 25% range’ for utilisation we need an NPV. To do this we always need to make some assumptions, here are mine:

1.      As previously stated Avanti don’t consistently break out data revenue and equipment revenue so I have to assume that these move roughly in step.

2.     Maximum Revenue is assumed to be proportional to capacity in GHz with ARTEMIS, HYLAS 1 & HYLAS 2 adding up to the $238m current max revenue at full utilisation. The revenue capacity of HYLAS 2-B, HYLAS 3 & HYLAS 4 are proportional to their capacity.

3.     Avanti depreciate satellites over 15 years which is meant to be there useful life. Therefore I assume they generate no revenue 16 years after launch. This looks like:

4.       Cost of Sales remain at 60% of revenue. Admin Expenses at $35m pa and debt interest at $64m pa.

5.       Utilisation increases 10% each year to reach full utilisation at 100%.

An NPV is only as good as its assumptions of course but with these (that could be considered aggressive in some areas e.g. 10% discount factor when the debt is yielding 10%, they are funding with debt & equity and equity holders are taking more risk) yields an NPV10 of only $480m – considerably less than the outstanding debt:

With the current 182p share price you have a market cap of c.$400m and an EV post capex of c$1.0b vs a $480m valuation.
Of course this analysis ignores revenue from any future satellites Avanti may develop & launch. The reason is that these would have to be funded via further debt and/or equity. In lieu of this I have excluded satellite depreciation. With these assumptions Avanti would be FCF positive in 2019 however not earnings positive until 2021 or later with depreciation charged to the income statement. Note that the senior secured notes are due in 2019. Since Avanti will not be able to repay these from cash flow they will be reliant on credit markets at the time to refinance this debt.

Assuming they can increase the utilisation more rapidly at 20% pa to reach full capacity then the NPV10 increases to c$840m. More than the debt but still makes the equity significantly overvalued. Add in an extended life of each the satellites for 5 years at full capacity in addition to the rapid utilisation and you still get an NPV10 at a discount to current EV.
In conclusion, unless Avanti can rapidly increase capacity utilisation much faster than they have done in the past or if they can generate significantly higher pricing & margins then the equity could well be worthless. That Avanti’s management seems to prefer finding creative ways of giving the appearance of growth in their commentary rather than actually driving the business to create this growth, gives me little confidence that they will deliver improved growth or margins in the future.

Disclosure: Since the current equity valuation seems to be pricing highly optimistic scenarios for both pricing and utilisation that I believe to be unrealistic based on the performance of the company over the past 2 years I am currently short the equity.