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Avesco: Byzantine Financial Statements and Unconventional Strategy

July 03, 2014 | About:

Summary bullets:

  • Avesco has a strong stable business with consistent revenues generated per pound of assets purchased
  • Large distribution, unfortunate recent events, confusing decisions by management and confusing annual reports have scared investors
  • Depreciation costs mask the no-growth earnings estimates of a company that has consistently chosen to invest all of its earnings back into its business

Avesco Plc (LON: AVS) is a small British media services company trading at ¾ x last year’s reported earnings. This is due to a large windfall that is not in the revenue I’m showing (or that the company reports.) The business buys equipment and rents it to events that require large screens and other such devices for events ranging from corporate events to sporting events. This business is not solely a rental company. They provide services that come with the products that they rent. The idea here is on the one hand you’re renting out relatively complicated equipment to people who don’t want it around after their event is over. On the other hand you’re lending the people who know how to use the stuff. The revenue comes from three divisions with different margins. It is my understanding that they all do the same thing with varying ratios of services to rental leading to different margins.

Looking at Avesco’s annual reports, a clear picture does not readily emerge. On the face of it, this is a company that does not have any consistent earnings. As an aside, the financial statements are fairly byzantine.

Lots of things have happened to Avesco recently. Firstly, they received £45.7m from a settlement with Disney (DIS) from a lawsuit that stretches back into the days before the company existed in its present configuration. Then, they decided to distribute £28.5m of it to shareholders, and use the remainder to buy back 10% of the shares outstanding, among other uses. This is how we arrive at 2013’s earnings: they got a very large lump of money relative to market capitalization. At the same time, 2013 was one of the worst financial years for Avesco in recent history, in part due to one of their divisions breaking off to form its own entity. The part that broke off was a particularly stable part of the operation in Germany, and what remained after was unsustainable. Therefore, they are in the process of closing the remaining operation and relocating equipment. This resulted in lost revenue, restructuring costs, and doubts as to the company’s stability and competitive niche.

Across the board, divisions had lower revenues in 2013, which management attributes to the fact that there was no event for them to get involved with on the scale of the 2012 London Olympics. They predict that this will resolve itself in 2014. Even years, they say, are better, which seems to check out in their revenues. Revenues have been predictable. Aside from the idea that even years seem to be better than odd years, there isn’t much to say. Costs have been a bit unpredictable. The investment thesis depends on why costs have been high.

The per share results for the company are as follows:

This is a company with growing revenues and a fairly stable net book value. Almost all of it is tangible, although there is some room for interpretation when it comes to what this would be worth in a liquidation. I’m not convinced that book value really matters here. Assets depreciate rapidly enough, and are specialized enough that if this company goes bust I doubt you can rely on this. However, as an estimation of earnings power, it is useful. Financing is low, indicating low leverage. That’s worth noting because there are plenty of rental companies out there with high leverage to make thin margins produce more substantial earnings. A large part of assets and consequently of book value is “hire stock” which is basically rental equipment.

As you would expect, given that financing is out of the picture, the major costs of this business are depreciation on the equipment and salaries on the people. Wages go into cost of sales, and all the equipment and related charges go into operating expenses (OPEX). Looking at the chart of these over time, cost of sales maintains a stable ratio with revenues, while OPEX does not. This indicates that salaries vary with revenues, and the company has its wages under control. Something more interesting is happening with OPEX, which contains depreciation on the equipment. If we look at the ratio of revenues to assets things are a bit volatile. If we look at revenues to hire stock (rental equipment) the relationship is more stable. Every £1 of hire stock generates £1.4/year in revenue. That’s a little surprising, and probably explains the low leverage. Again this company is not really a rental company, and so it shouldn’t look like one on paper. Most people can’t buy a house for for $100,000 and rent it out for $11,500/month, but our “house” in this case comes with a lot of amenities. It’s not just the equipment but also the people who know how to run it.

To get at asset spending, you can show assets at cost with additions and disposals. Looking at the assets this way eliminates depreciation, which is a very real expense. However, it also shows that since 2008 asset expenditures have been lumpy. There are clearly a lot of additions in the last few years. 2012 was an “investment year” as they geared up for the Olympics and bought lots of equipment. Pay attention to how much assets are really growing. Disposals are roughly half of depreciation. Looking at additions only, you can see that this company is pouring money into their asset base.

Untangling the mess that is 2013

You might notice that so far I’m hand-waving about 2013. Looking at per share trends in growth of revenue and total costs, Avesco has operated with costs higher than revenues since 2008. 2013 stands out as a particularly bad year, but there are some adjustments to make. Looking at wages, which are one of the larger expenses for the company, wages increased about 13% from 2012 to 2013, bringing them to £42.3m. Of this, however, £3.3m resulted from payouts of the Disney settlement to employees. Another major cost for the company, depreciation, actually decreases. Restructuring costs are mentioned in the annual report as costing £4.8m, but they cost £2.9m in 2012, and there is some mention that these costs will continue into the future. So in a sense we really can’t start removing all of these one-time things because they don’t seem to be very one-time. For sure though, costs related to the payout from the lawsuit should not be anticipated to continue. It’s worth noting that even after adjusting for payouts, wages are still higher in 2013 than in 2012.

An important point is why they chose to distribute all that money. Given what we now know about the business, I would argue that it’s just because they can’t spend it. They already have invested a lot in replacing equipment and they can’t invest more. Their equipment depreciates over 2-10 years so they don’t buy this stuff and wait for an opportunity. Depreciation has trended from 16M to 20M while assets at cost have varied from about 80M to about 130M. I think it’s fair to assume average depreciation on a weighted basis is something like 5-6 years. Somewhere in OPEX there’s also going to be costs associated with storing it. The other point that I haven’t mentioned much is that for reasons that are probably historical, Avesco’s managers seem to think it’s an investment company. This really doesn’t make sense given the current state of affairs where Avesco is a pretty simple leasing/services business. It does I think illuminate the capital allocation plans, however. They apparently like to keep investments at about 100%. At these levels they have plenty of room to employ leverage if they need excess liquidity, and it keeps them exposed to business opportunities. The reason they can do this is because they can reduce their costs somewhat fluidly if business falls off a cliff, as in 2009. I also think this is a pretty good reason to believe that they will never have earnings in the classical sense, choosing instead to invest roughly 100% of their earnings in the business.

I think I’ve spent a lot of time trying to convince you that this company is making large investments in itself at the same time that it’s getting hit by large one-time charges. I think I’ve also tried to tell you that it has a book value way higher than its current share price and that management has virtually no worries regarding working capital.

The last piece we need is underlying earnings. This is going to come from subtracting out depreciation and replacing it with an estimation of no-growth investment. Probably this number will underestimate earnings power because there will be wages in the cost of sales figure, as well as other associated costs of investing in the business that won’t show up. Still, doing this in an extremely conservative fashion using the average disposals number or a touch higher as a no-growth estimate of asset expenditure gives you maybe £10M/year instead of about £18M/year. Underlying earnings should be something like £8M/year. You can dock this figure down a hair if you don’t have faith at all in management’s ability to deploy cash profitably. And that, I would posit is how you get to a rationalization of the current market cap. However, I think this is pretty negative. Even if everything that can go wrong does, this company would probably still be worth more than it’s trading for.

I don’t believe the assets should be taken as a serious evaluation of the company’s value, but I do think you can extrapolate earnings power based on them. If you give the underlying earnings a mid single digit multiplier, which I think is pretty conservative for this business, you’re going to make a lot of money buying now. If the growth trends continue and this company’s earnings actually increase that’s additional upside.

Risks

A cursory look at this security will tell you that it’s an illiquid microcap in the UK with a large bid/ask spread.

There’s a fair amount of tail risk. Equipment can be lost, damaged or stolen resulting in large losses. The employees are extremely valuable, but they’re also able to break off an start their own business. One reason not to do this is that this business is volatile enough that I think you’d be better off being part of Avesco with its access to credit facilities. Because the equipment depreciates fairly rapidly you also need to have consistent revenue streams. Avesco can compensate by courting different clients to cover the weak spots. Based on this, you’d expect the division that broke off to have been extremely stable relative to the rest of their portfolio of clients, and that’s exactly what management said happened. So breaking off might be harder than you’d think at first. Nonetheless it’s a delicate balancing act filling in the year with clients to keep utilization high. Any major client choosing to forego Avesco’s business could have pretty ugly effects on revenue in the short term. My feeling though is that they’ll be able to survive the temporary rough patches and fill in the schedule with events to do. They seem to have a fairly wide range of clients they can sell to, and they seem to have fairly niche expertise. Overall I think this is a business that isn’t too likely to have a high total shareholder return over 10 years because of risks and instability.

Other risks: LTIP structure, high management emoluments, you could make an argument for this company caring more about management interests than share price.

Catalysts

Are there any catalysts? Maybe one. 2014 is supposed to be a lot better than 2013 was, and once the numbers come in you might see some enthusiasm come back to the shares. They did the World Cup in Brazil, so those numbers won’t be available yet, but could be pretty great so long as they kept their utilization up for the rest of the year. The 10% buyback has been announced but isn’t in the numbers I showed yet. Everything will be 10% better in 2014. Unfortunately the market doesn’t seem to believe this company is worth much, so having that value concentrated in fewer shares isn’t really a catalyst.

There’s also a sort of inverse catalyst in that you could argue that the preceding few months have been such a swamp that they have been a catalyst for a lot of negativity in the shares which might abate. I don’t think though that this is the kind of investment where you are looking at a clear path to a higher share price in a known time frame.

It’s always possible someone could try to buy this or put some kind of activist in. It’s also possible that management would try to sell Avesco at some point.

Further reading

The red corner did a recent, good, concise write-up of Avesco here. It has also been mentioned here in 2010. Do your own research before investing.

Disclosure

I recently initiated a long position in Avesco. Figures quoted in this article should not be taken as substitute for GAAP accounting figures reported by the company. This is an illiquid microcap with a fair amount of tail risk. Do your own research before investing.

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