Don’t Spare the Rod: Critique of Investment Research Reports

Time WarnerA beginning analyst sent me a research report to discuss: Ensco PLC Write-Up

Now before I start, realize that when I was beginning, my idea of a research report was to mimic Cramer.  Buy because the “chart” looks good and I gotta feelin’.  One time my hedge fund boss said his time was worth $1,000 an hour so the six minutes he took to read my incoherent report meant that I OWED HIM, $100.  Well, we all have to start somewhere.  The point of this exercise is to learn.

Buffett’s punch   idea may apply. If you only had twenty investment ideas over a lifetime–one every two to three years–would this be it? Would you put all of your money and family’s money into the idea and why?

Or, you pretend that you have a 45-second ride in the elevator to the top of the Time Warner building with Carl Icahn while selling your idea.

Bill Miller once said that money managers had the attention span of knats. You had to summarize your thesis and then give three or four supporting reasons within thirty seconds.

My critique of Ensco PLC

Instead of four paragraphs to tell me what Ensco does, perhaps you can be more succinct while putting forth what is compelling about your investment thesis.

ESV (Ensco, PLC) is an owner/operator of offshore contract drilling rigs/services that is trading at X% under tangible book value.  This is a cyclical, asset-intensive business subject to swings in natural gas and oil prices. Over a fully cycle, the company earns normal returns on capital of XX?

The price: Enterprise Value

Returns: over several prior cycles?

Capital structure and terms of debt?

Bottom line: this is a non-franchise or asset-based investment that is currently and cyclically out of favor.  OK.   But if this is an asset based business what are the assets worth?  You would need to dig into tangible book–what is there?   What is the current and expected replacement value of their assets? Liquidation value?  Is their fleet of rigs unique? Who are their competitors?  Any hidden assets or potential assets like, say, NOLs or assets outside their core business for example?

What is their cash flow and owner earnings?   I would like to see enterprise value over EBITDA-MCX over the past decade to get an idea of how the market priced ESV over a cycle.

Who is management? What skin do they have in the game? Are they good operators and capital allocators? Insider buying?  Who owns this company?  I don’t have much to go on in the above report so I jump to my handy VL: ESV_VL.  Whoa!  I see debt has jumped about 35% from 2013. How does their capital structure compare to competitors?   It seems like there isn’t much free cash flow. Capex eats up most of the company’s cash flow.

Where is the margin of safety? Book value has been growing but during an up-cycle in drilling. What happens in a prolonged down-cycle?  What are the risks?   You mention a DCF? Where did that come from? Your assumptions?

I will let others in the Deep-Value group chime in, but for a first-ever research report I give a D- which isn’t bad. At least the writer has good instincts to look at an out-of-favor company, but the core analysis of the assets needs to be provided. Also the competitive landscape.  Obviously, it is a business without a competitive advantage due to the low and cyclical nature of the returns, so how does this business compare operationally, financially and value-wise to their main competitors? Who are their customers and how are they faring?

The only way to improve is to write, practice and look at other reports. Go to www.valueinvestorsclub.com and sign up. Then look at the highest rated ideas and study those along side the 10-K of the company mentioned.

Study Other Examples of Research

Or The_Security_I_Like_Best_Buffett_1951  Warren Buffett on Geico.

https://sumzero.com/sp/bc_winner (you may have to paste into your browser) and as reference, Rockwell Automation Inc and ROK_VL from a Deep-Value member, Thomas Harris. We can critique this next if you wish.

Carl Icahn paid $500,000 for an investment bank to furnish a report on breaking up Time-Warner: lazard_twx (worth a look!) and Icahn was right about Time Warner

Analyzing Debt

Sell ABX

ABX Sombull along with Barrick Annual Report 2014 and Barrick 1 Q 2015

https://www.coursera.org/learn/learning-how-to-learn

http://en.wikipedia.org/wiki/How_to_Read_a_Book

Stay with it………writing is hard and finding great ideas even harder.

7 responses to “Don’t Spare the Rod: Critique of Investment Research Reports

  1. Just some quick thoughts:

    1. Margin and turnover figures don’t really mean much unless you put them into context. Try comparing them to the corresponding figures for similar businesses.

    2. A few of the onshore drill rig operators have had solvency problems in recent years. So it might be a good idea to do a little more work on the capital structure. For example, look at the standard ratios like working capital ratio, quick ratio, and compare net working capital with non-current debt. Take a look at interest coverage too, eg by working out average EBIT for the last 7 years and comparing to current interest charges (or the average EBIT figure divided by current balance of debt). Also, consider the maturity profile of the debt and any available details as to financial covenants. Furthermore, take a look at the company’s liquidity/solvency position back in 2009, when the oil prices dipped to very low levels, to see how the Ensco held up then.

    3. Further to 2, I might be good to think some more about stability of earnings over say 6-7 years.

    4. Personally, I don’t think that ROE is very helpful where the balance sheet has been puffed up by large amount of goodwill and similar purchase accounting items. I would try to calculate an adjusted ROE to exclude such items and also to remove the effect of any amortisation of such items. (Alternatively, just use the Greenblatt calculation of ROIC.)

    5. It’s good to describe the business, but you should also state why you think the Ensco share price is so cheap. For example, you might say that with the decline in oil prices there has been pressure put on high cost oil projects, that offshore oil exploration tends to be higher cost than onshore, and so Ensco’s share price has suffered because people expect it’s drill rig utilisation rates to fall, etc, etc. Once you have worked out the reason, try to come to a view as to whether this is a temporary problem, how it might be resolved and how long that might take.

    For extra bonus points, you could try to find any available details of private market sales (or public company takeovers) of similar businesses over the last 5 years. Try to estimate the EV/EBIT or EV/Sales for any such transations and compare such figures to what Ensco is trading for now. This kind of thing approach involves a lot of work but it can be very enlightening.

  2. Nemo AGAIN provides insightful, helpful comments. One way to find comparable valuation data is to go back to merger proxies in the industry. So if three years ago Schlumberger bought out a driller what did the merger proxy provide for the valuation/reason for purchase.

    Another, is to read the annual reports of several competitors over the past several years–especially in a down cycle like 2009–how did their capitalization and valuations compare. I think the simplest industry I ever looked at was the title insurance business; there were only four major players, but it took several weeks of reading and talking to people to grasp the essentials of the business. Unless you pull all-nighters, I don’t see how you can really understand the drillers in less than a few months. BUT you can build on that knowledge to find other ideas in the drilling industry or transfer to another industry.

    Even studying the Lazard TWX report can help you! KEEP LEARNING!

  3. Thank a lot, John and Nemo, for the very insightful feedback. I really appreciate you taking the time to guide me on the right direction. I took note and will be updating my templates.
    Thanks again.

    • Keep focused because then you can build off your work. Don’t hesitate to send your work to the deep value group for comments.

  4. About the ABX,

    Currently their EV/EBIT are as follow:

    ebit (Net cash provided by operations)
    4.5850 5.3150 5.9830 4.2390 2.2960

    TEV 57.5150 58.0840 49.5580 33.6760 25.5170
    TEV/EBIT 12.5442 10.9283 8.2831 7.9443 11.1137

    As i have wrote in the group – you get a company with current market cap of $15 B which 3 years ago was $55 B (3 times more this is cyclical business), $ 2 B operating cash flow for 2015, $915 M of debt payment, total assets of $33B and one of the best AISC in the gold business as well the properties. ABX has one of the best gold properties.
    Also recently they hired some guy is some start in the field.
    ABout the debt – as they are making expense cutting and selling properties i think they will make it.
    Gold is not going to $500 – this is my opinion. In contrary i think as the world is running on DEBT (US, EU, Japan) i think gold price will rise from the current level (it may drop a bit first)

  5. One observation:

    I am comparing barrick with Oceanagold
    and find the oceanagold better.
    Let me explain>
    First ocenagold operating cash flow is $230M while barriks is $2 500
    but the market cap of barrick is $15B while Oceanagold is $700MiL
    also EV/EBITDA of Oceana is around 4.
    So you have 20 times company with 10 times cash flow. – Oceanagold is better
    Plus their AISC is also low – around $850.
    Much more to write but this is just to a fast view..

    • Thanks, but also look at reserves, size of resource, location and future capex requirements.

      Also, the cost of capital for Barrick may be lower. You need to look at many different variables.

      On the whole, smaller companies like Lake Shore Gold, Detour may be cheaper but they have only one resource, etc.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.