Flybe – A dog is a value investor’s best friend?

I think there is one thing we can all agree on – no one has much love for Flybe (FLYB.L). Even after a recent small bounce it has lost almost 50% of its value over the last year and is now trading at a PTBV of just 0.8 and an EV/EBITDA of 1.4.

And many would say that’s fully justified. For example a few comments from here:

http://www.stockopedia.com/content/is-now-a-good-time-to-buy-flybe-130478/

‘The real killer for me is these persistently low level load rates despite the generally favourable conditions for air travel.’

‘They must surely be near rock bottom on load factors. Generally when LF's get to 65% is frequently game over for an airline.’

‘Also, if they barely make money with low oil prices & the economy moving along nicely, what happens when we have a recession linked to high oil prices?’

‘Anyone short or considering shorting here?’

UK Small Cap Analyst & Blogger Paul Scott also turned negative on the stock following poor Q1 trading:

http://www.stockopedia.com/content/small-cap-value-report-27-jul-2016-vcp-staf-nxr-flyb-144477/#comments

‘However, for me this is one disappointment too many, and I'm currently in the process of ditching my position in the company today. The load factor dropping to 70% is worrying me, and I think it's possible that this company may never move back into proper profitability.’

Here’s the main reason for being bearish in 1 graph:

Load factor is passenger numbers divided by seat capacity. This doesn’t look like the turnaround story investors were promised. It can be hard to make money when your average plane is less than 70% full.

Things are unlikely to change soon either early indications for Q2 in the Q1 trading statement indicate that there is a risk that H1 won’t be significantly above break even.

http://www.investegate.co.uk/flybe-group-plc--flyb-/rns/q1-2016-17-trading-statement/201607270700123242F/

And after all this is to be expected, Warren Buffett has given us repeated warnings against owning an airline:

"I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did."

So that’s that then. £FLYB is a dog and best avoided…Or is it?

The opposing view

Flybe popped up on my radar again when it appeared as the highest risk-reward & ROOIC pick for a value investing Hedge Fund:

http://www.gwinvestors.com/wp-content/uploads/2016.07.19-Q2-2016-Letter-to-Investors.pdf

When smart value investors suggest a 10x upside then I certainly start to take notice.

Essentially their argument is:

• CEO is a smart guy with extensive industry (EasyJet) and restructuring (Gores Group) experience who is committed to only flying profitable routes and will quickly take action to eliminate routes that are facing too much or loss-making competition.
• Clean under-leveraged balance sheet following 2014 rights issue means that there is very little chance of bankruptcy and the company can easily whether periods of poorer trading due to external circumstances like terror attacks.
• Have now dealt with and ring-fenced legacy issues surrounding leases on unprofitable E195 regional jets.
• 2.5 years into a 3 year turnaround plan with key issues like plane utilisation and staffing levels now at industry norms.
• Plane choice of Q400 Turboprop allows profitable routes from smaller airports at lower passenger numbers.
• Main competition is often rail travel which is more expensive and slower in most cases.
• Flybe has a long runway (pun intended) of short profitable routes in Europe that it can add to drive growth over the medium term.
• Their valuation metrics on an EBITDAR, EBITDA & EBIT basis are so undemanding that a move to trade at an average for the sector would see the share price multiples of today’s price.

The Alternative Load Factor Story

Now a lot of that makes sense but on the surface doesn’t seem to line up with the story that the load factor graph is telling us. However when you graph the components of the load factor separately and apply a trend line to help remove seasonality you get a different story:

So the load factor decline is due to passenger numbers increasing at a slower rate than the seat capacity increase. According to the CEO this is as expected since a new route takes 2 years to develop the volume to become profitable and the company has added seat capacity recently.

We can actually model the lag in passenger numbers following an increase in seat capacity. Taking the Q1 figures to avoid seasonality I am going to assume a route starts at 55% load factor when opened and then hits 65% after 1 year and 75% after 2 years. I assume mature existing routes stay at 75% load factor. This is what you get when I model this against past Q1 numbers (to avoid seasonality effects I compare just Q1 to Q1):

Notice how closely the model matches the actual Q1 passenger numbers. When the seat capacity growth moderates the maths means the load factor tends to return to the 75% that I’ve assumed for a mature profitable route. This year Flybe have moderated their seat capacity growth in response to a weaker market and will only add 6% this year (calculated from the plane deliveries this year.) If I assume zero seat capacity growth after this year the load factor trajectory will probably be something like this:

i.e. a return to a 75% load factor 2 years after seat capacity growth stops.

Of course this model doesn’t prove that growth in seat capacity is the sole reason for the drop in load factor but does give some confidence that it is at least part of the explanation.

The reality is also more complex since there is a strong relationship between load factor & yield (revenue per passenger.) There is high price elasticity meaning that small changes in pricing have big impacts on passenger numbers. The company will adjust pricing to maximise revenue per flight just this revenue will be bigger for more mature routes that need less marketing for public awareness and get scale from airports.

Valuation

Flybe is very low on multiples of EBIT, EBITDA & EBITDAR compared to its peers and with those metrics likely to increase in the future they will look even better comparative value unless the share price responds. However in general I’m not a big fan of sector multiple comparisons when valuing a business since the whole market or sector could be under/over-valued or there may be differences in tax rate etc. that are not properly accounted for. For this reason I prefer to value businesses on a Discounted Cash Flow basis. It is clear that a DCF is at best an attempt to understand the factors influencing intrinsic value not a way of determining an absolute value. They are equally as dependent on assumptions as sector multiple comparisons but at least the assumptions are explicit and can be tested or varied as required. Here I am going to make some pretty conservative assumptions.

Assumptions:

• Load factor as per above profile with 75% maximum.
• Zero growth in seat capacity beyond this year.
• Contract revenue flat.
• Other operating revenue flat.
• Fuel pricing drops 32% in line with oil price hedges next year +6% seat capacity increase.
• Staff costs +2% for 3 years as per recently announced pay deal.
• Airport & route charges, ground operations & maintenance track seat capacity.
• Aircraft rental charges flat as capacity expansion is through ownership.
• Marketing & distribution, Finance costs flat.
• Other Operating Expenses includes things like Insurance, Travel Costs, Property Rent, etc. so it is conservative to assume this is proportional to seat capacity.
• Cash Flow = profits over the long term. i.e. depreciation = maintenance capex and working capital flows are neutral.
• Grounded lease cost £20m this year, £10m next year.
• 20% UK Tax Rate
• 15% discount factor.
• 6.67x terminal multiple (equivalent to 15% discount factor applied to no growth scenario) from FY19/20.
• £49.4m net cash = £62.2m net assets - £7.8m restricted cash - c.£5m share purchase (see next point)
• Fully diluted shares in issue of 218.7m (note employee 5% share aware will be met with on-market purchases.)

This gives a fair value estimate of £1.23 or 2.3x current share price even after the recent rise from sub 40p to the current 53p.

A less conservative discount rate of 10% and hence 10x final multiple would see a fair value estimate of £1.88 or 3.6x current share price.

This is based on a management team doing the basics of running an airline right: scheduling, pricing utilisation but not much else. If we assumed that the CEO can actually do what he says and add further profitable routes to the network, oil price stays low & revenue/passenger increases slightly then 10x share price is not unreasonable.

Obviously reality will not match my model of smooth growth. Each quarter, half or year will be noisy as external factors like fuel pricing or consumer confidence provide head-winds or tail-winds. With net cash on the balance sheet though Flybe has the ability to weather these periods of poor trading and capitalise on the periods of good trading.

I see three major risks to the type of upside I am modelling here. The first is a long severe recession in the UK that would seriously impact passenger numbers across the industry for an extended period. This was certainly a risk with the Brexit vote however PMI indicators seem to have bounced back recently. I am actually surprised at the apparent strength of the UK economy in the wake of the Brexit decision. Flybe has significant economic exposure but given its higher proportion of business travel than most other low cost carriers it is much less impacted to weak sterling reducing leisure travel that could be a challenge for other low cost carriers. And of course if you were concerned about the severe recession scenario you would own no UK stocks. The second risk is another cash-rich airline competing aggressively on the shorter regional routes that Flybe fly. Unless this competitor is willing to fly Q400 or similar aircraft Flybe will have the cost advantage but as Warren Buffet alludes to we shouldn’t underestimate the willingness of airlines to burn shareholders capital on unprofitable route expansion. I think the risk of an airline competing across a large proportion of Flybe’s routes is limited by the fact that it would be cheaper to simply buy Flybe. Which is my third risk. That someone else runs these numbers and Flybe gets taken over for less than a conservative estimate of its intrinsic value.

All things considered I’m struggling to find a better risk/reward situation in the UK market at the moment. At least for investors willing to live with the volatility of short-term results.

Disclosure: Since my analysis indicates a very significant potential upside to Flybe shares I am long the equity. I may be wrong. I reserve the right to change my mind at any time if I perceive the facts have changed.

The Big Short

I recently caught the film in the cinema. I’d read the book a few years ago but none the less the film was both entertaining and thought provoking. As one would expect from a film about financial markets it had a lot of relevance to investing.

Firstly what a great trade it was. The main characters in the film spotted an asset that was priced as if its components were uncorrelated (as they always had been in the past) and realised that they were in fact highly correlated. The best thing was that the trade had a very high pay out. By buying Credit Default Swaps on Mortgage Backed Securities Derivatives they were paying an insurance premium and getting the principle in return if they were correct. These sort of opportunities don’t come around very often but when they do they are highly lucrative.

The film showed really well why value investing is hard. Buying or selling something because its market price varies significantly from a conservative estimate of true value sounds great but the only reason that you get mis-pricing is because very few people agree with this assessment. It can be psychologically hard to go against the consensus opinion with your own money. The film showed that when you do it with other peoples’ money there’s always a chance they will call you up, shout at you and then threaten to sue you.

Short selling is hard. When you take a short position you are essentially betting that something will fail. This often has real world consequences like people losing their house or jobs. I think this is one of the reasons that a lot of short selling focuses on frauds. Yes a fraud is usually a zero which is the best return you can hope for as a short seller. But I think there may be something deeper too. By exposing fraud it is quite clear that justice is being done whereas it is less clear cut with a business that is merely overvalued or fails due to management incompetence. That said I do believe that for good businesses to succeed, some bad business need to be starved of capital and fail. I personally have never had a moral issue shorting a company. But as the character Ben Rickert points out in the film, when they do fail sober reflection is probably a more fitting reaction than triumphalism.

Despite being a great trade I do think the film showed all the participants making mistakes.  Mike Burry in particular was too early putting his trade on in 2005. This is always a difficult part of investing, particularly for those of us of a ‘Value’ bent so I’m not sure really what he could have done to prevent being early. Where I think he did go wrong was with position sizing. He thought that his history of past returns was enough for his investors to stick with him through all short or medium term under-performance as long as he was right in the end. He suffered from the illusion of permanent capital and in the end had to gate his fund to get the permanent capital he needed to see the trade through. I reckon a lot of value investors who took large positions in specific stocks and underperformed in 2015/2016 may find that they were suffering from the illusion of permanent capital. We all sometimes underestimate how long it will take for a particular investment thesis to play out and we would be wise to treat each investment like a DIY project. Think how long it should take, then double it…and double it again.

I think the final mistake that most of them made was underestimating the counterparty risk in the trade. The character Mark Baum’s hedge fund was part of Morgan Stanley so had exposure to the financial crisis despite his short position. All the others had bought their CDS from investment banks so would have been potentially valueless had the investment banks failed while they still held them. If they truly saw the scale of the coming financial crisis they should have had CDS on each counterparty and maybe even a long government bond position to protect themselves further.

And as always in investing luck played a part. Several of the characters found the trade because someone else introduced them to it. And the founders of Cornwall capital were able to access CDS because of a former neighbour.

The secret of finding the next Big Short? Be open to new ideas, bet on value, look for asymmetric returns, focus on position size, consider counterparty risk up front and practice humility when it pays off.

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 12^th 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 17^th 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.

Is Avanti Communications' equity worthless?

I originally wrote a version of this post on stockopedia.co.uk 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).

http://www.avantiplc.com/

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

http://www.investegate.co.uk/avanti-comms-group--avn-/rns/1st-quarter-trading-update/201511120700084267F/

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: http://lordshipstrading.blogspot.co.uk/2014/11/avanti-avn-questionable-quality-of-sales.html
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: http://www.shareprophets.com/views/16999/avanti-communications-a-letter-to-the-financial-reporting-council-re-2015-accounts . 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

http://www.investegate.co.uk/avanti-comms-group--avn-/rns/avanti-communications-full-year-results/201509160700221954Z/

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.

Using Short Interest Data to Make Better Investment Decisions

Shorting individual stocks is a hard game. Investors who do so face high costs to borrow the stock, bear the risk of unlimited losses, and are rarely popular amongst the mainly long-only investment community. To be a successful shorter you generally have to be an excellent analyst, a good trader and most importantly be right.

In the UK since 1^st November 2012 there have been disclosure requirements in place that require anyone short more than 0.5% of the outstanding share capital of a company to declare this.

http://www.fca.org.uk/firms/markets/international-markets/eu/short-selling-regulations

The Financial Conduct Authority provides a daily spreadsheet with these details. Originally I used to download and manipulate the data in Excel but very helpfully Castellain Capital has provided a website that does it for you:

www.shorttracker.co.uk

Given that short funds tend to be ‘smart money’ how much notice should you take of a large short interest in a stock?

Firstly it is important to check for corporate actions – there are many funds that are involved with takeover arbitrage. This strategy involves assessing the likelihood of a takeover going ahead and judging if the market has mispriced this. A typical position to take account of a mispricing is to go long the acquired company and short the acquirer. So if the company you are interested in has announced a takeover of another and this hasn’t been fully priced into the market expect short positions to increase.

The second thing to look for is the presence of convertible bonds issued by the company. These are often used for a volatility arbitrage strategy called delta hedging. This strategy requires the trader to be short the equity of the convertible. Hence if a stock has a large convertible bond you can expect a large short position to be declared.

If you have either of these cases a declared short position is nothing to be concerned about since they are related to strategies that don’t require the equity to fall in value to profit.

Also seeing ‘Quant funds’ declaring a short is not usually that concerning since they are not doing research into specific companies but buying and selling a very wide portfolio of stocks based on certain factors (value, momentum) that have historically delivered over/under-performance. By buying a stock with a quant-based short you are of course buying something that is either in a medium term downtrend or looks expensive on typical value metrics like P/E. This should act as a warning sign but if you are a value investor buying a bombed out stock and can explain why it may appear expensive on typical value metrics but is indeed undervalued this shouldn’t deter you. A good example here would be an oil explorer that has fallen in response to the drop in oil price. It may have no earnings and a high price-to-book but still hold a very valuable oil asset. Of course you have to be sure that there is a clear route to monetisation of that asset through sale or development that remains viable in a low oil price environment. If you have done a solid valuation based on conservative assumptions then a quant fund declared short shouldn’t put you off since it is unlikely that they have done a similar analysis.

After you’ve ruled out corporate actions and convertible bonds then the presence of discretionary stock picking funds that are short should be a big red flag. Given the inherent risks of short-selling those funds also tend to share research and be activist – through publishing reports or going on financial TV to explain their negative views. Therefore if you see a large increase in a declared short position it should act as a very strong signal to be wary – negative news is likely to be on the way.

Given the breadth of companies available to an investor to allocate their capital to, one may simply want to avoid these companies. However, although I take increasing discretionary short interest very seriously, short sellers still suffer from the same biases as the rest of us. It is my experience (although I cannot prove this with objective data) that short sellers sometimes get it wrong on individual companies when they engage in sector or ‘story’ shorts. This is where they take a sector view like ‘oil is going down’ or ‘The UK High Street is Dead.’ These investment theories may be well founded but their implementation will never be perfect when expressed through individual stocks. Therefore where you see high short interest around a particular sector like UK Supermarkets but your analysis shows that one of the companies in that sector is significantly undervalued due to the unique nature of the business then that can be an opportunity. If your investment thesis proves to be correct then you will get very handsome returns since you have short funds who will become large buyers of the stock as the company releases positive trading results and the price rises.

An example of this at the moment I believe is Home Retail the owner of Argos & Homebase which (as of 6th November 2015) has an 8.9% declared short interest according to:

http://www.shorttracker.co.uk/company/GB00B19NKB76/all

Why do I think the short funds are wrong?

Firstly they have got it wrong in the past. Looking at the history of Home Retail’s short interest, it peaked at 15% in Jan 13 when the share price was c£1.20 and dropped to its lowest point around mid 2014 when the share price was £2+. The nature of these businesses has not changed significantly since this period and the progress to an increasing digital store portfolio is significantly more advanced today than it was in 2014.

Why might they be short?

This is where the story comes in. The UK high street has serious structural problems. Retail is increasingly moving online. The historic high cost rents of the high street are a drag on profits compared to an internet retailer like Amazon.

What might they have the missed?

•  Argos is the UK’s second biggest internet retailer behind Amazon (http://www.imrg.org/the-top-50-online-retailers-in-the-uk-june-2015). I doubt many hedge fund managers shop at Argos but plenty of people do.
•  Like most retailers they are highly cash generative and run negative working capital so funding growth is easy. They are currently investing in digital stores and same-day delivery infrastructure. Very few companies will have the range and infrastructure to be able to offer same day service. Amazon are just starting this to so if this is a unique value proposition for people then this may end up like a duopoly with only Amazon & Argos with the scale, range and delivery infrastructure to offer this. They have cash on their balance sheet t
• They own their own credit book – that is money they have lent to customers to buy from them. This isn’t the highest quality of credit, they have taken provisions against bad debt of 10.1% of the loan book, however net of provisions this is still worth £550m. This is an asset that could be sold off or securitised. This may not be the best thing for the business as a whole since they use this for promotional activity (interest free credit etc.) however it remains an asset that could be sold to fund investment or simply return cash to shareholders.

This of course is not an exhaustive analysis, there are some negatives like a pension deficit and some onerous rent provisions and given the level of short interest one would want to do a thorough analysis. However given the £0.9b market cap and netting off the £550m financial services loan book you are not paying much for the underlying business – and that in my opinion makes it worthy of further investigation.

Should you average down or up?

One of the most contentious topics in investing seems to be the issue of whether you should average up or average down. That is whether you should consistently add to a winning position or add to a losing position. Great investors hold strong and often contradictory stances on this topic and their views are widely quoted. E.g.

We like to buy stocks which we feel are undervalued and then we have to have the guts to buy more when they go down. Walter Schloss

‘Always sell what shows you a loss and keep what shows you a profit’. Livermore

...a price drop [is] as an opportunity to load up on bargains from amongst your worst performers…a price drop in a good stock is only a tragedy if you sell at that price and never buy more. Peter Lynch

Don’t garden by digging up the flowers and watering the weeds. Warren Buffet

One of the mistakes investors can make when reading these quotes is to read these as strict rules. They often miss the caveats contained within them. For Schloss averaging down has to be in something still ‘undervalued.’ Lynch says a price drop in ‘a good stock’ is an opportunity not a price drop per se. Knowing Buffett’s strong focus on the performance of a business not the market price I’m sure his ‘flowers’ are well performing businesses with good economics and his ‘weeds’ are badly performing businesses. I doubt any of these investors are recommending taking action purely on price action alone yet often we interpret them as such.

The other issue with saying one is ‘averaging down’ or ‘averaging up’ is it suggests that your current average buy price matters. It does not. To the fully rational investor a historic trade price is completely irrelevant. A rational investors asks themselves ‘given all current information do I have the right position size in relation to the risks and potential return?’ not ‘should I average up or average down?’ (See my blog post on portfolio optimisation)

Rules like ‘never average down on a losing position’ can be used to try to overcome behavioural biases like loss aversion but they should be recognised for what they are – an attempt to overcome one’s personal bias – not a general investing rule that everyone should follow. Rules can be very useful way of addressing behavioural biases (see: my blog post on portfolio rules) But for a rule to be relevant then it must address a bias that has led to past under-performance. If you have a tendency not to recognise when the fundamental investment case has significantly deteriorated and have a history of adding to positions that never bounce back then set a ‘don’t average down’ rule. If you have a habit of being overconfident and over-sizing your winning positions then set a ‘no averaging up’ rule.

For everyone else simply optimise your portfolio regularly based on the latest information available and forget what the average buy prices of your portfolio constituents are.

Are financial discussion sites dangerous for our wealth?

There are many investment websites where private investors and market professionals discuss potential investment ideas. Seeking Alpha, The Motley Fool, Stockopedia and ADVFN are just a few of the ones I regularly read. They can often be a fantastic source of knowledge, wisdom and experience as contributors from all walks of life freely discuss their investment ideas and strategies. When you add in Blogs & Twitter there are a myriad of ways to read or share investment ideas. While there are undoubtedly some misleading contributions from people who manipulate information for their own ends, in my experience most people who post do so out of a genuine desire to gain and share knowledge. And experience teaches you to spot those whose opinion could be questionable.

So why do I think discussion boards have the power to lead us to poor investment decisions? Primarily because contributors to these sites make very public statements about their opinions and psychology teaches us that once we’ve done that we find it very hard to change our minds on a subject even when the facts change.

The desire to appear consistent is a very powerful psychological effect. Robert Cialdini explains this in his excellent book, Influence: The hidden power of persuasion. He describes how getting people to agree to and write down statements was used to great affect by the Chinese Army on American POW’s in the Korean War. The Chinese would start by asking a POW to agree to a simple statement such as ‘America is not perfect.’ Since this was undoubtedly a true statement as far as the majority of POW’s were concerned then complying with this request wouldn’t have seemed a big deal. However once they had written the statement the POW’s would be asked to write a list of ways in which America is not perfect. Once they had agreed in writing that ‘America is not perfect’ it became very hard not to comply with the second request and add some details. This list would then maybe read out on the camp radio with their name making the public commitment complete. Compared to the harsh conditions of the Korean POW camps the Chinese camps were far more effective at getting prisoner compliance. Breakouts were very rare and given their public statements of compliance POW’s often turned in fellow countrymen for minor rewards such as a small bag of rice.

Psychology researchers replicated this effect in a kinder setting in an experiment conducted in California. They approached households and asked if they would mind displaying a small sign on their lawn asking passing drivers to ‘drive carefully’. Since careful driving in their neighbourhood was a public good that all householders were interested in and the signs were not particularly disruptive it’s not surprising most of those approached agreed to display the small sign. The power of the desire to be consistent with one’s former actions was shown two weeks later when the researchers returned to ask if the householders would mind displaying a much larger and uglier ‘Drive Carefully’ sign that they’d mocked up in a brochure. Here over 50% of householders who’d displayed the smaller sign agreed to display the larger sign compared to less than 20%  in the ‘control group’ of householders who were not first approached to display the smaller sign. That’s a big change in average behaviour from a small public commitment.

The power of public commitment can be a useful aide when trying to do more exercise or give up smoking. However when it comes to the complex and rapidly changing environment of investing being fixed in one’s opinion is rarely good. Once we publically take a position, like a positive write-up of a company on a website, it becomes much harder not to commit further by buying shares or increasing a position. And much harder to sell a position for which we’d previously made positive public statements.

I sometimes I find this effect even manifests itself in the amount of research I do. The more I research a company the more I want to appear consistent to myself that the hours of work are worth it, the more likely I am to find justifications why this is a good buy (or sell) and more likely to take a position. Then given the amount of research done I’m more likely to share this publically and compound the effect.

And the most worrying thing about the ‘consistency’ effect is that we may be completely unaware of its influence on us. The same researchers who did the initial experiment with the 'drive carefully' sign repeated it but rather than using the small sign as the initial influencing factor they asked residents to sign a petition agreeing with ‘keeping California beautiful.’ Surprisingly this, effectively nonsense petition, had the same effect as the small sign in activating the residents’ sense of civic duty and led them to accept the large ‘drive carefully’ sign in almost a similar proportion. But more assiduously, whereas maybe some of the participants in the initial study may have thought ‘hang on a minute, I’m only accepting this large sign because I accepted the small one two weeks ago’ in this case I would imagine very few people made the link between accepting the large sign and the petition they signed a few weeks ago. Yet the evidence is that it was a significant influencing factor for many of them.

Sharing research and investment ideas can be a key part of getting feedback and improving your investment skills as well as being part of an active part of an online community. However next time you make a public statement about the investment merits of a particular share it’s worth thinking in advance of what events would cause you to change your mind and sell (or cover a short.) Even better write them down, so you have made a public commitment to yourself to change your mind if the facts change and you’ll at least want to appear consistent to yourself with that.