Category: Schaffer Corporation

See my original post on SFC here.

Howe Leather

Howe Leather hit the ball out of the park with it’s 1HY18 result. The biggest surprise to me was the improvement in earnings margin. To illustrate how big an improvement this was, the table below compares my estimate of the 1HY18 EBIT margin to historical EBIT margins.

Management attributed the strong margins to an appreciating EUR:USD exchange rate as 60% of their variable cost are denominated in USD. Based on historical exchanges rates, I compared the change in average EUR:USD and the prevailing EBIT margins for various periods.

If EUR:USD continue at these levels till the end of the FY18, I won’t be surprised if 2HY18 EBIT margins exceed 20%. Current EUR:USD levels are still below average levels if compared to the past 10 years. EUR:USD maybe back on an uptrend since the decline in 2014.

Revenue for 1HY18 was $105 million and management announced that “steady state” volumes have been achieved. The company looks set to easily beat my previous revenue forecast of $180 million for the full year. Although management has indicated the expected revenue for Howe Leather in 2HY18 to be similar to 1HY18, I noticed that since 2015, there has been a seasonality factor which wasn’t previous present; see table below:

If this seasonality pattern continues in 2HY18, a combination of this seasonality factor with the current EUR:USD exchange rate would an even better result in 2HY18.

Building materials

In my opinion, management achieved a good price for the Limestone quarry assets and Urbanstone business; which were not making money. The selling price was approximately 1.5x of the net asset value.

Property division

Not much material change on this front except that the company has gotten state approval for rezoning of the Jandakot property. The next step is getting a local development plan. The Jandakot property development will be a few more years in the making.

SFC Capital

The company announced the formation of a new division to invest the cash generated from Howe Leather. I’ll wait till we get better clarity on how the capital is being invested before giving my opinion on this.

This has been a stellar report by SFC and the share price has acted accordingly by rising to a 12 year high. In many ways, you could have predicted the strong results due to:

• Management guidance during the mid November AGM for further increase in volumes and profitability in 1HY18
• The Chairman then proceeding to buying $1.37 million worth of shares two weeks after the AGM. An important lesson here!

Bottom line

I still think the company is undervalued. At Howe’s current volumes and profitability, the market capitalisation of $172 million still only mostly represents the value of Howe Leather. There is value upside from 1) revaluation of the Jandakot property to recognise conversion to industrial use, 2) future cyclical upturn in construction 3) development of the North Coogee and Jandakot sites.

 

Schaffer’s share price is on a roll. The share price surpassed the $10 mark this week on two very positive announcements.

The first positive announcement is that Schaffer recently received town planning approval for increasing the development size of their Jandakot property from 12 hectares to 39 hectares (or 390,000 square meters) for future industrial developments. Any future development will still be subject to various planning, environmental and infrastructure approvals. However, given comparable industrial land values of $200 per square meter, this is very positive news.

The second favourable news is that John Schaffer recently purchased 140,000 shares on-market at an average price of $9.80 per share. This is a cool $1.37 million endorsement from the Chairman.

In my opinion, there maybe a risk that the share price may pull back after rallying nearly 100% over the last 12 month (I don’t know and don’t speculate on short term share price movements). However, in the medium to long term, I believe there is more upside due to the increasing volumes and margins at Howe and potential multi-million property developments at North Coogee and the Jandakot properties.

For my original post on Schaffer Corporation, see here.

I wanted to wait until the annual report was out before commenting on the FY2017 results. The segment information contains a bit more granular detail than compared to the summary financial report. Anyway, here is my take on the results for the various divisions:

Howe Leather

The results were very strong, revenue growth and margins were ahead of my expectations.  Revenue grew by 10.2% yoy and EBIT margin improved from 3.1% (FY2016) to 9.4% (FY2017). This EBIT margin is based on an EBIT of $16 million (before deducting employee participation unit costs). As indicated in the results presentations, drivers for the margin improvement include:

• Lower processing cost in Slovakia compared to Melbourne.
• Improved yields due to more familiarity with the programs
• Reduction in hide cost.
• Reduced freight cost due to shipping direct from South America to Slovakia. Prior to this, the hides were shipping to Melbourne first to be processed and then on shipped to Slovakia to be cut.

Other more subtle improvement in the business is customer diversification. Howe has reduced their dependence on its largest customer:

Looking forward, I think revenue and margin will continue to improve. I’ll set myself up for regret by making a forecast; based on 2HY17 revenue, it suggest that Howe’s revenue (assuming exchange rate stay the same) can exceed $180 million in FY2018.

Yields should also improve as new programs commenced in FY2017 and it takes time and experience to achieve the efficiencies. Therefore, it is likely that the company can further improve on its EBIT margin.

Longer term, I think the investment made in Europe is important as it shows both commitment and brings Howe closer to its key customers.

Well done Howe and in my opinion, management fully deserves their employee participation units.

Building Materials

This division continues to be a laggard and has been for the last few years. This has not been unexpected with the low level of construction activity in WA. The mining sector appears to have bottomed out but I think we’re still some years away from seeing improvements in WA’s construction sector.

Property division

The most interesting assets here are 10 Bennett Avenue and Lot 702 & 703 Jandakot Road. Landcorp has already sold lots in the Shoreline development and from what I can see from googlemaps, not only have the infrastructure been completed for the first phase, the first residential buildings have being constructed. The beauty about being able to wait till all the infrastructure and residential homes are constructed is that this will greatly de-risk the development and increase its value.

The company is seeking to rezone the Jandakot road property from rural to industrial. I think their chances with the council are good given their neighbours, Jandakot City is a large industrial development. The value from the potential rezoning is significant, after putting in the necessary infrastructure (access, power, sewerage, etc) land values could potentially increase from the current value of $17.50 per sqm to $200 per sqm.

Although the share price has increased since my last post, I still think the market is undervaluing the company and there is more upside to come. I continue to hold.

 

SFC announced its half year results a few days ago and on the key issues, things are progressing as planned. The market seems to be recognising it’s value with the share price moving up quite nicely before and after the half year result announcement. Key items from this HY result for me are:

1)  Margin improvement at Howe Leather

Profit margins increased from last year as indicated by the EBITDA margin improving from 4.6% (FY16) to around 6.7% for the 6 months to December 2016. The Slovakian operations are producing operating efficiencies which I expect to continue. In my previous post for the valuation of SFC, I have assumed a run rate EBITDA margin of 7.8% and management has flagged further efficiency gains from finishing and cutting so I think this is achievable.

Although lower hide prices supported improved profit margins, adverse foreign exchange movements had a double whammy negative effect on margins, due to the appreciation of the AUD against the EUR (SFC’s sales are in Euros) and depreciation of the AUD against the USD (SFC’s purchases are in USD). So if the foreign exchange movements don’t worsen then I expect the earnings for the full year to be significantly higher than in FY16 (fingers crossed).

2)  Cashflow generation

SFC generated strong operating cashflow of $15.6 million for HY17. This has caused net debt to fall from $58.2 million (FY16) to $46.7 million (HY17). Cashflows were generated from profits and improvements in working capital as shown below:

The move to consolidate the hide finishing operations in Slovakia has improved both profit margins and working capital requirements by shortening production time. Based on my analysis, I believe SFC has cycled through all of it’s excess inventory (I may have overestimated the excess inventory in my last post).

3)  Sharp downturn in the building material sector

I was surprised by the extent of EBIT falling ($1.2m – HY17 vs $2.4m – HY16)  for this sector especially since things appeared to be improving in FY16. Nonetheless, in the last post I have already taken a conservative approach to valuing this segment (30% discount to net assets).

In summary, the bedding down of operations in Slovakia is going well which I expect to continue. The building material sector is continuing to suffer due to the overall contraction in WA’s construction sector which is expected to worsen this year with the completion of a few major projects.  SFC mentioned that there are no current plans to start developing the land at 10 Bennett Avenue, which is prudent given the soft prices and the oncoming supply of new apartments in the Shoreline development area. Overall, I have not changed my valuation of SFC of $6.50 – $7.70 and at the current share price still happy to hold on to the stock.

 

SFC released its FY2016 preliminary financial results a few days after my initial post.  I took at while to give an update as I wanted to wait for the annual report (which has more information) and to speak to management before updating my valuation.

Here’s the update to my initial post. I recommend reading it first if you haven’t already done so.

Automotive Leather

Revenue grew by 53% to $155.1 million as expected due to the new programs and EBITDA was $7.2 million excluding one-off expenses of approximately $2.5 million (start up cost for new Slovakian finishing plant, redundancies and write down of decommissioned assets). A summary of the revenue and EBITDA for Howe is as follows:

Management had previously flagged that earnings in FY2016 would take a hit from the operational restructuring exercise and that it will take time to bed down the new programs and get some efficiencies in terms of cutting etc. Nonetheless, the normalised EBITDA margin was still lower than what I was expecting. After a bit of scuttlebutting, I think that the new programs were priced a little sharper to win the work and “get in the door” of a new client.

I have updated my valuation of Howe based on the updated revenue and margin figures. As volumes for 1HY17 is expected to be at the same level as 2HY16, I have used this 12 month figure as a proxy for recurring revenue. My margin assumption was based on the average old program margins for the first $100 million of revenue and then a lower margin for the balance from the new programs. I have also reduced the multiple from 5.5x to 5.0x to reflect the size and margin difference between Howe and Eagle Ottowa (transaction at 6x EBITDA multiple).

There are a few positive tailwinds for Howe:

• Hide costs have come down which should boost margins. There are limits to this given the nature of the supply contract where prices are negotiated annually.
• Lower hide finishing cost and improved working capital efficiency as a result of moving finishing facilities to Slovakia.
• Potential to increase volumes given the entry into Mercedez Benz (expand supply to other models).

Building material division

There have been some signs of improvement in the building material (paving) division but Delta (pre-cast concrete) is still performing poorly due to the subdued construction activity in WA.  The segment results have improved over the last two years and I have increased my valuation of this division but maintained some conservatism as it is still not earning a required return on its capital.

The WA construction sector is still subdued but there are some key transport infrastructure work which are in the pipeline.

Property division

I have not changed any of my assumptions except to consider the value of the North Coogee property if developed into a 175 unit residential development which is a likely scenario in the next few years if the apartment prices do not totally collapse in Perth. The apartment values have been coming off as a result of the mining downturn but the falls in values have been gradual.

As an undeveloped land, I still maintain that the land is worth circa $15 million (83% attributable interest) but if developed my high level calculation shows that the project could potentially generate after tax profits of $25 – $30 million.

SFC valuation

I have updated the sum-of-the parts valuation based on two scenarios, the first scenario assumes the North Coogee land is sold as undeveloped land and the second scenario assumes development of the site.

Although the share price has moved up since my initial post it still trading below these levels.

Schaffer Corporation Limited (SFC) has been listed for over 50 years on the ASX.  It was started by George Schaffer who arrived in Australia from war torn Europe. Today the Company is run by the founder’s son and is still very much a family owned business. It has never missed a dividend in each year that the company has been listed; this puts it in a very elite group.

So why do I like it?

• It’s cheap, I believe there is an adequate margin of safety at current share price of $5.17.
• Management is open and honest plus shareholder’s interest are aligned (family controls 30% of the business),
• Company owns some strategic real estate in WA where positive development in the surrounding area has taken place.
• Howe Leather’s volume may grow by 50% in FY2016 with future savings from streamlining operations.

SFC is made up of three divisions:

1. Howe Leather, this subsidiary is 83% owned by SFC and supplies automotive leather upholstery to automotive brands such as Land Rover, Audi, Mercedes, Nissan, Toyota and Ford. The company purchases its hides from South America and processes the hides in its finishing facility in Victoria before being shipped to its cutting facilities in China and Slovakia. Howe’s focus is to supply high quality product to European luxury car makers and competes against large American companies as Lear, GST Auto Leather and smaller European based companies such as Bader and Boxmark.  Exports account for 95% of sales.
2. The building materials division consist of 2 businesses; Schaffer Building Products and Delta Corporation. Schaffer Building Products manufactures and retails a range of paving, walling and landscaping products. Delta Corporation manufactures a range of precast and prestressed concrete floor, beam and wall products together with custom made precast panel and beams product for infrastructure, building and resource projects.
3. The property division owns a mix of properties commercial properties that are both investment properties and development sites.

Howe Leather

Howe’s financial results from 2011 – 2015 is as follows:

Revenue has been on a general uptrend since 2011 with sales over the period being driven by new and continuing vehicle programs from European car manufacturers. The abnormally high earnings in 2014 was due to purchase of hide stock prior to the depreciation of the A$:US$ which temporarily reduced the cost of goods sold in that year.

Howe has started 16 new programs (Mercedes Benz) over FY15 and FY16 which have resulted in sales volume being 41% higher in Dec 2015 that the previous corresponding period. In 2015 the company has started a new hide processing and finishing facility including an expansion of the cutting facilities in Slovakia which will reduce working capital and increase profitability once it’s ramped up due to economies of scale and the lower labour cost. All this has caused an abnormally high level of inventory on hand.

Those are the rosy bits. This business however, is not without its challenges. The key ones being:

1. Howe’s sales are dependent on actual vehicle sales which Howe has no control over. For e.g. Howe supplied the Land Rover Evoque model which achieved good sales which benefited Howe’s sales from 2012 – 2015.
2. Howe is a relatively smaller player compared with Eagle Ottowa (owned by Lear) and GST Auto which are approximately 8x – 10x larger.  These competitors are able to produce at lower cost given their larger economies of scale.
3. There are more leather suppliers than automotive makers which tips the bargaining power towards the car companies.
4. Foreign exchange. Howe buys the hides in US$, sells the finish product in Euros. So a high US$ and a low Euro hurts the bottom line. Currency fluctuations are out of management’s control.

The industry has undergone consolidation over the past few years. Automotive Leather Company (ALC), Seton and Eagle Ottowa were acquired by Exco Technologies, GST Leather and Lear Corporation respectively. I believe one of the factors why Howe has managed to increase its sales is because of the shrinking pool of tier 1 leather suppliers and the automotive manufacturer’s desire to keep the balance of power in their favour by keeping the smaller suppliers.

Comparable transactions

Howe is of similar size to ALC and is currently also experiencing a ramp up in growth from the new Mercedez programs. For the purposes of valuing Howe, I’ve selected an EBITDA multiple of 5.5x.

Building materials division

This division is currently underperforming given the downturn in WA’s economy. Although this division has exposure to the Eastern States, WA’s resource and residential construction and renovation sectors are still significant markets. With the market downturn in both markets, this had resulted in declining sales and profits since 2014. Profits have suffered more than sales due to increased competition eroding profit margins.

Financial performance over the past 5 years:

For the purposes of valuing this division, I was not able to identify any comparable transactions. Listed building material suppliers are much larger (e.g. Boral, Fletcher, James Hardie) and in my opinion not very comparable.

This division is debt free and as at June 2015 has assets of $48.3 million and liabilities of $15.8 million which results in a net asset position of $32.5 million. For the HY16, the asset position increased slightly but the liabilities were undisclosed.

This division has the potential to surprise on the upside given the continued subdued expectations. For example, in HY16 this division performed much better than expectations, which was one of the reasons why SFC’s share price rose after the HY16 result announcement.

Property division

This division holds the company’s investment properties and development sites. The company has a mixed of properties that are either directly owned or owned through a syndicate. The table below shows the properties owned by Schaffer.

For the purpose of this analysis, I have ignored the value of the properties used by SFC as these are required for ongoing operations and not held for investment purposes.

The market values provided in the above table are sourced from the company’s HY16 investor presentation. I understand that the company has sought the advice of external property valuers in presenting the numbers above. I haven’t verified each of the property values but I believe the above market values are reasonable given:

• In Dec 2015, SFC sold a property in Melbourne (Oce House) for approximately $9.5 million. In June 2015, this property was valued by SFC at $9.7 million.
• I have performed some analysis on 10 Bennett Avenue, North Coogee and believe that the above market value is understated.
• Overall management has been shown to be honest and transparent. There is not much incentive for management to overvalue these properties as all the properties are all carried at historical cost on the books.

The two interesting properties are 10 Bennett Avenue, North Coogee (North Coogee) and Lot 103 – 104 Jandakot Road, Jandakot (Jandakot). The North Coogee property is a 2.1 hectare site smack in the middle of the Cockburn Coast Redevelopment Area. The Cockburn Coast Redevelopment is a State backed project which will be developed over 10 – 20 years and will transform the former industrial area into residential and commercial community with up to 12,000 residents. Check out the details here: http://www.landcorp.com.au/Residential/Shoreline

Land for the first phase of the development called Shoreline has already been released to developers. Landcorp has advertised sale of a 2,875 sqm apartment development lot at $2.6 million ($904.35 per sqm). SFC have stated that the North Coogee site could potentially house 175 residential units.

The Jandakot property is a large property over 500,000 sqm, is about 15 minutes south of the CBD, close to major transport routes (Kwinana Freeway) and adjacent to Jandakot City. Jandakot City is a project to develop 150 hectares of commercial land which forms part of the 620 hectare Jandakot Airport site.  Although the project still has some way to go, so far the Jandakot City project has been successful and has managed to attract some large multinational companies (e.g. Aldi, Schlumberger) to the area. Jandakot City is an example of what SFC’s Jandakot property could become but it is still very early days.

Valuation

I have used the sum-of-parts method by valuing all 3 divisions separately.

Howe Leather

The above forecast EBITDA is not an estimate of FY2016’s EBITDA but an estimate of the EBITDA’s run rate based on the new volumes. Management has mentioned although volumes are higher in FY2016, there are set up, testing and “learning” costs associated with the new vehicle programs which will dampen the EBITDA in FY2016. Note that the above EBITDA has not taken into consideration the savings from the expanded Slovakian’s facility.

Building materials

Given the lack of information available on the valuation of comparable companies and transactions and the fact that the division is not current returning an adequate return on its capital, I have simply valued this division by applying a discount to its net assets.

I’ve tried to triangulate the value by sense checking against an implied return on equity. The value seems reasonable albeit on the conservative side but is still only a very rough estimation. The relatively smaller size of this division makes it less of a concern.

Property Division

I’ve adopted all of SFC’s presented market values with the exception of North Coogee. I’ve based North Coogee’s value on the sale of comparable property at $904.35 per sqm. Therefore, I’ve assessed the land to be worth $19 million assuming full ownership (SFC owns 83% of the land). The net increase in property value is as follows:

SFC’s valuation

This implies a 30% margin of safety at current share price of $5.17. This margin of safety could potentially be larger as Howe’s profit margins is likely to improve with the expanded plant in Slovakia and if SFC’s manages to develop residential units on the North Coogee property.

So why doesn’t the market appreciate SFC’s value?

I think the simple reason is the low trading liquidity of the shares; low number of shares compounded with the founding family owns 30% of shares and at a market cap of $72 million, it’s far below the radar of institutional investors.

I think this is a good investment with a positive growth potential, a margin of safety, diversified business and a nice 4.8% dividend yield at current prices.