Looking to the future
Last post, I looked at Communisis as an investment over the last couple of years – and why it’s been so successful, as both a company and a share. Those two don’t necessarily go hand-in-hand; the performance of any investment you make isn’t just contingent on the performance of the operations underneath it all, but also on the price you purchase at. I concluded that, among other things, one of the key factors was the way the business had fundamentally changed (they were shifting to more advanced technology) while still appearing the same, a factor I think a shrewd investor might have been able to identify. There was, however, also a good deal of more intangible stuff – management have clearly performed well, for instance – that is perhaps harder to ascertain simply from the documents on their website.
Either way, we are in the here and now, and the question any nervous holder always wants to know more than any other is what to do. For an investor who spends the vast majority of his time researching bombed out shares which look cheap, and mostly for perfectly valid reasons, holding a share which has quickly appreciated carries with it a lot of unease. It’s not too bad if the value is easily defined – Barratt was an easy sell decision, because I bought on the basis that their land wasn’t so grossly misvalued that they should trade a a price to book of 0.3, but equally I didn’t feel that, even with whatever bullish sentiment is floating around, they’re worth a lot more than their tangible assets. With a company like Communisis, though, the value has never been visible on the balance sheet; their business isn’t worth a lot because it has a bunch of assets which can be easily converted into cash.
No, the value is in the way they go about doing business and the relationships they’ve built up – and that much becomes obvious if you look at the returns the business has enjoyed over the last few years. Over the last 5, they’ve averaged well over 20% returns on capital – mostly because their capital base is so small. Working capital is negative, so no tie-up there, and plant/equipment/leased assets are also fairly light, though I wonder if the accounting in the accounts over-depreciates. Just a hunch, and I doubt it’s by that much, but real economic assets here might be slightly higher than reported.
Returns like that pose two interesting questions for us as investors, and both of those questions make valuing a company more difficult. Firstly; are these returns sustainable? Economics tells us that, in competitive markets, returns will always tend towards ‘normality’ – the cost of capital, a figure which is essentially imputed from the volatility associated with the returns. Answering this question, then, is basically like ascertaining whether you think the market Communisis are competing in is really competitive, or whether they have some edge which allows them to enjoy more substantial profits. Secondly, and more of a positive slant; will they company be able to grow? Companies earning big premiums on their cost of capital grow profitably – if Communisis can borrow money at, say, 10% – and invest that money into a business which earns 20% – it’s easy to see how investors will benefit. Hence, the value of growth becomes more and more apparent as returns improve.
The awkwardness, and what I suspect is an important roadbump I need to get over as an investor, is that I feel nervous whenever growth is necessary to justify a valuation, no matter how likely that growth is. I’m far more comfortable with a story of undervalued assets, or accounting hiding how much money is being made. The truth, I suspect, is that it’s finding this combination and getting this balance right that really defines a great investor – the prudence to buy only on the cheap, but the willingness to understand where conservative valuation methods might be wrong with a business that has genuine advantages.
Does Communisis have genuine advantages, then? Something which will enable it to keep earning returns like it has? Well, I can’t answer it fully, but you can infer something from the fact that Communisis is still winning so many contracts. All 10 of the largest UK building socities use Communisis, and the largest bank has just signed up to using them extensively (as well as, presumably, many others – they’re simply referred to by Communisis as ‘Bank 1’, ‘Bank 2’ and so on). Customer relationships are longstanding. There is a clear and undeniable value in parterning yourself with big companies and doing something better than they can do it themselves – particularly over a long timespan. As relationships become entrenched, the cost of changing becomes much higher – and as Communisis seem to be trend setters in this area anyway, it seems unlikely anyone would presently want to move.
Judging by the fact they just raised £20m through equity (nicely timed – they’ve taken advantage of a share price higher than it has been for 5 years), they’re planning on investing to grow, too. Not necessarily grow revenues, I note – much of the really low margin stuff is disappearing or getting passed along to others – but grow profits by involving themselves with the higher margin stuff. There’s a distinct shift taking place from being a printer to being an integrated marketing company, with all the fluffy stuff as well as the paper and ink. This semi-paradox – growing profits while not necessarily physically growing the business – is probably best exemplified by the fact that they just raised £20m only to announce that they’re shutting down their Manchester site for an annual cost saving of £4m, though of course there are restructuring costs. The business is changing.
I put together an indicative sort of revenue/profit graph with some of the information we know and some estimates, just to see how the figures looked. I’ve noted my main assumptions in the right hand box. Realistically speaking, I suspect the first assumption is the one most likely to come out better. The last of the assumptions is the one that should be met with the most scepticism, since it comes only from management’s ‘target’ of reaching double digit margin (ex. pass through) ‘within 3 years’. It doesn’t seem unreasonable, to be honest – margins have been rising considerably year on year, and there’s £4m of apparent cost savings coming, so we’ll see.
To be honest, I’m very uncertain about Communisis now. The potential is immediately obvious – from the (almost heretical!) perspective of a growth investor, we have a company which has longstanding relationships with a huge number of enormous companies, with which is appears to be succeeding in selling more and more higher value services and products. They seem to be significantly larger and better positioned than their competitors – and indeed, they’re even moving into Europe. Revenue growth is still being driven by ‘pass-through’, though – essentially just contracts taken on and given to printers at cost, by way of building a relationship with the client, so that sort of growth is still being flattered. Will all the empire building pay off? It seems to have so far – but then, it’s not particularly cheap any more.
As I was catching up with Communisis, I noted that they’re actually releasing a set of results next week so, in time honoured style, I’ll postpone my decision until I have the information then.