Disclosure: I have an interest in Northern Bear shares
Northern Bear is a small, northern English building services firm traded on AIM.
To understand any business, you need to understand a little about the history. Northern Bear was, as was often the case in the good old days, cobbled together with flowing money and attractive public markets. Several construction-related groups joined forces to create a platform company, with the intention of buying further complementary businesses and scaling up the combined group. Isoler, Roof Truss, Springs Roofing and Wensley Roofing all joined forces to create Northern Bear, which floated in late 2006. Whether they would have made a success of their acquisition strategy is difficult to say, because they got a pretty short pop at it before the recession crashed the party. Debt-financed purchases were out. Anything construction related was definitely out. In some senses they weren’t so dissimilar from Judges in that they planned to provide exits for small, owner-operated building services firms at attractive multiples for the group. A key difference is that they were rolling up a market which saw swingeing cuts in spending in 2008-2009, and thus necessitated a complete change of strategy.
Unsurprisingly, as a small business in an out-of-favour sector, Northern Bear was up against the wall for the recession. The debt pile which had looked comfortably manageable years before was under pressure because of both a contraction in the profitability of the group, and a tightening in the standards lenders were willing to allow. 2x EBITDA with headroom to 4x became 4x EBITDA with, I imagine, a banking group breathing down your neck to get it back to 2x.
What saved the business was its exposure to social housing and public sector projects.
We are through the recession now and able to look at a group with, admittedly, some of the scars of a difficult past. Namely:
– A platform strategy that was never able to acquire scale – illiquid and too small.
– A shareholder base comprising mostly the operational guys running the subsidiary businesses – succession issues?
– A catch-22 share price problem, whereby both liquidity and scale (presumably through acquisition) would help the share price, but are difficult to execute without a higher share price in the first place.
Why should an outsider shareholder want a passive, minority stake in a difficult business like this?
The case for the Bear
Having set the scene, one might now look at the positives. One might notice that the share count is down significantly since 2009. There are very, very few small companies who have actually reduced their share count in the last few years; most issue shares like confetti, either for acquisitions or in share option plans. The group has also consistently been profitable since 2011. Both of these factors are likely a consequence of the ownership structure – it is still predominantly owned by the people who are running the individual businesses. While it creates all the problems I mentioned above, it also means you are genuinely aligned with the people who have the most influence on how the business actually performs. And they really are key; Northern Bear is just a nice name for a number of roofing businesses, some more general building services, a little plant leasing and some more niche companies in fields like asbestos removal. All of this is at a scale where the real driving factor is just the guy who gets into the office every day and makes the decisions that keep things ticking. We are not talking Balfour Beatty, layer-deep reporting structures, thousands of employees and internal corporate finger-pointing.
As a consequence of this alignment of interest, it’s not a massive surprise to see that – unlike most construction companies with their deeply-discounted rights issues at the bottom – the group has massively delevered, off its own back, since the worst of it in 2010. The group’s cumulative £8.4m free cash inflow (roughly equal to the current market cap) has reduced debt from £8.9m at peak to £2.5m now, paying dividends as they went. That’s free cash flow after all growth investment, by the way; after absorbing the modicum of working capital needed for growth and the increase in PP&E. After all, in that time frame, the group grew revenues from the trough of £27.6m to hit a peak of £41.7m in 2015. This is an admirable effort. It takes less than ten seconds to think of more disastrous construction or building-services companies than you would want to name. My supposition is that these businesses are so operationally intensive, with management so crucial, that severing the link between ownership and management is a very bad move indeed.
Lots of people have an aversion to small companies solely by virtue of their size – they assume that they are poorly managed, or have deep structural issues. Northern Bear has weathered the storm much better than most of its larger peers. It’s a wholly credible performance.
Small service firms aren’t trivial to value. Lots of the ‘value’ is created in things that aren’t on the balance sheet. Many firms – manufacturing, leasing, financials – can be neatly analysed by looking at their return on capital. But that doesn’t make a huge deal of sense for a business which doesn’t really require any capital to grow, relying more on good operational management, local relationships, winning contracts and keeping good staff. You don’t invest in a big construction company because they have more capital than their competitors; you might invest because you think they are less likely to screw-up a contract by missing margins by a few percentage points.
Let’s be clear – this is not a ‘wide-moat’, fashionable, Buffett style stock. Lots of people trying to analyse construction service-type companies drone on about deep customer relationships and differentiated, niche service offerings. This is usually complete and utter drivel. These businesses are always competitive, and deluding yourself that you have found the Google of building services is a ridiculous path to even start setting foot on. What matters is keen management.
So I’m inclined to be old-fashioned. Organisations have inertia. I suppose that Northern Bear’s future, barring any better indicator, will probably look like its past. Here’s what its past looks like:
Both last year and the year before, the group generated £1.5m in net profit, or 19.4% of the current market cap. This is a P/E of just over 5. Those earnings are significantly over-covered by the cash earnings of the business. Whether you think those earnings are a fair representation of the company’s economic profit is an important question – in the first of the two years, the group reported a £259k bad debt write-off, as well as £239k of non-cash financial costs related to some unamortised bank facility fees – necessary due to the refinancing so as to save cash costs in future years. In the second year, the group reported their worst 6-month revenue performance for years as the north of England was buffeted by terrible weather:
I can see how high winds might make roofing work difficult.
Anyway, assuming you think these are two run-of-the-mill years – that they will have to write off chunky receivables every year, or will have terrible weather, or will structurally need to continuously refinance – the earnings figures are spot on. If you think they are two relatively harsh years to view the company by, you might be a little more generous. As it happens, I actually think they nicely capture some of the many things that can go wrong. It’s nice to build in a little conservatism.
The 5x P/E Northern Bear trades on – about half as expensive as its wider sector – is hence based on two years with relatively conservative earnings numbers, and those earnings numbers are actually backed by cash inflows. I hate to belabour the point, but I am going to. Construction-related companies which actually generate meaningful cash are as rare as hen’s teeth.
Management comments in their recent results were as circumspect as usual – apparently the year has ‘started well’, but it ‘remains a source of frustration that the Group is often not in a position to influence when contracts commence’. This reads to me like a simple advance warning that there may be some slippage from the first half into the second half, but I may be reading too much into it.
I assume that on a reasonable basis, without extraordinary weather or extraordinary bad debts (but with a splash of both – such is life) the company can probably bring in something like £36m of revenue next year – a significant reduction on two years ago and a slight reduction on this year, but probably prudent given that average employee numbers are down significantly (albeit this is a predominantly backward, not-forward looking measure). In the absence of more data to suggest that the slowdown was contained to last year, I carry it into this one. I feed this through to EBIT of £2.04m and net profit of £1.47m – they are benefitting from cheaper finance costs. At an 8x multiple, the shares are then worth 64p.
This is over 50% upside. If they pay out half of that net profit as a dividend – eminently feasible given the cash generation – the stock would be yielding 6.3% at 64p.
By getting slightly more aggressive, we go off to the races. If one assumes they can match 2015 revenue levels – a good year – but now carry through the benefit of the lower finance costs, ongoing back-office cost savings (back-office employees have been decreasing every year) and don’t have some of the exceptionals – we might have a bull case that looks like this:
169% upside is pretty appealing, I don’t think any of the assumptions are too heroic. EBIT of £2.9MM is about 10% higher than its previous peak in 2015, so not pie-in-the-sky, and the rest just follows through from there. A 6% dividend yield is my best guess of where it’d shake out should they stabilise and start a normal pay-out regime.
But who knows – it is, by virtue of its size and insularity, a crapshoot.
The Goodwill Conundrum
Actually, we do have a little bit of a clue as to management’s instinct on how profitable the business might be. The following isn’t a trick that can often be used, but Northern Bear is a pretty extreme case – a company which has an enormous pile of goodwill greatly exceeding its own market cap and enterprise value.
Every year, as part of their IFRS accounting, the Board of Directors have to take a look at the pile of goodwill the company has on its balance sheet – that number which is supposed to represent all those intangible factors, capitalised at the formation of the business and on further acquisitions, which allow a business to make a whole heap of profit beyond what might be suggested by its tangible capital base. They have to break down the company and that goodwill into small ‘cash-generating units’ – typically business units where management decisions are made – and then undertake a cash flow forecasting exercise to build up a DCF. Essentially, they have to value their own businesses – just like we do as investors! The accounting policy is shown below:
So, what is the outcome of that exercise? Can we get any more information about the parameters of that DCF? Read on!:
So, essentially the board is telling us that with an 11% discount rate (10% + the AT LEAST 1% headroom they note) there is no impairment to the goodwill – these businesses are still worth more than they’re held on the balance sheet at. And they arrived at these valuations by looking at their ‘detailed approved budgets’ for next year, their profit projections for the four years after that, and applying a GDPish 2% growth rate in years 6-20.
Why is all of this relevant?
Again, I stress it is usually not. But in Northern Bear’s case, the value of their goodwill is £21.3m. Northern Bear’s own BoD have essentially said they are comfortable signing off on accounts which value their own subsidiaries at that figure.
And that is interesting given that the market enterprise value of the group today is £10.3m. The share price would have to increase by 150% to reconcile these two valuations.
I am open to all criticism of this analysis – yes, I expect the goodwill discussion is a perfunctory box-ticking exercise for the accountants and the audit team and yes, the forecasts could be wildly optimistic. But the quantum of the difference between goodwill-approved valuation and market valuation is far and away the biggest I have ever seen. If management took this exercise seriously, they must feel their business is dramatically undervalued in the public markets!
Having just rattled through that fun little exercise, whereby I show that the board are happy with their own carrying value which is dramatically higher than the market valuation of the business, I come on to one of my major concerns with Northern Bear. There are lots of risks to investing in small businesses like this, and most of them are operational. But operational risks I can deal with – they’re a fact of life for entrepreneurs everywhere.
No, what worries me more is the following, from their most recent interim results:
Having just established that I think the business is probably substantially undervalued – and having established that the board think that their business is substantially undervalued – you will understand that I was perplexed when I read the last bit of that passage. Raise external equity? I applaud the ambition, but even mentioning the idea when the valuation is so far away from a level that should be acceptable for issuance is a bad one. It is signalling to shareholders that you are happy diluting them – and that’s a pretty effective way of putting a cap on the price. There’s nothing worse for private investors than knowing that at some point, ‘due to illiquidity’, a bunch of City boys will get in at a nice discount to the current price.
And I’m not saying that will happen, by the way. As I mentioned before, Northern Bear have done an admirable job with their capital so far. But small-cap private investors are distrustful people, and – given AIM history – not without fair reason.
Having darted around my opinion on various aspects of the group – as a shareholder, but nonetheless a relatively uninformed outsider – I propose the following four points as my wishlist to the Board.
– Work to ensure there is publicly available research or newsflow on the company as a conduit between management and shareholders: There is essentially nil public information available on Northern Bear, and no forecasts. The free float of the company is small enough to make it essentially un-holdable for fund managers, the people who have internal research teams. This makes the dearth of research on Northern Bear all the more critical. Private investors drive the valuation of the group. Either the house broker or one of the many IR-related communications companies (doing director interviews, PR etc.) would help the company to get something – anything – out there to stay in touch with shareholders and help investors to more accurately value the company.
– Increase the dividend: The group’s net debt is now down to £2.5m, or less than 1x EBITDA. While there is some seasonality to this, and I am not comfortable with a particularly high level of debt in any cyclical company, the company has massively reduced this burden over the last few years. The group could have been significantly more aggressive with the dividend increase at year-end or the year before. The current pay-out, of ~£350k, is massively over-covered by cash earnings.
– Take seriously the share-repurchase authority the company has in place: If the company believes its own numbers, Northern Bear shares are an absolute steal, and represent money put to work at an ex-growth FCF yield of almost 20%. One way they can take advantage of this to the benefit of all shareholders is through the re-purchase of shares on the open market or in block transactions. Both of these are now feasible given the group’s debt reduction. Questions around liquidity here are fair – but given that the board’s utmost attention should be placed on narrowing the massive gap between the price and the value of the company, this may be a perverse positive. Perhaps mopping up some small number of shares on the open market would, with minimal cash outlay, get the group to a fairer valuation. From there, fresh equity can be issued in a proper placing, with a market cap that actually enables institutional participation. Yes, yes, I know it shouldn’t work like this – but it does.
– Do not issue new equity until the market price better reflects the group’s value: The absolute worst thing the company could do now is issue new equity. Not only have I shown it to be internally inconsistent, but it is also terrible signalling.
I know the dilemma facing the group: I have had this very discussion several times with management teams I have met over the last few years. How does one fix the valuation problem when a business is ‘too small and illiquid’ for the market? Sell-side brokers like to say that the problem would be fixed if just the company would issue equity. The equity would make the company more liquid, they say, and that liquidity will help to improve the valuation. The problem is that it is a self-serving half-truth. Sell-side brokers always want companies to issue shares; because that is how they get paid. Companies like AB Dynamics, Quartix and Quixant are all incredibly illiquid companies with significant management stakes, but which fetch valuations that reflect the quality of their businesses. Illiquidity is not the issue – the issue is a lack of communication. Quartix, for instance, publish investor videos and presentation slides accompanying all of their results on their website. This enables private investors to see what is going on and feel informed about the business in which they are invested. And, for what it’s worth, that stock has almost tripled since IPO.
An investment in communication and proper capital allocation is a genuinely good long-term one for shareholders. Buybacks or dividends may consume some cash now but – crucially – they allow the group to get to a place where issuing equity is actually feasible; at a proper valuation which enables both existing shareholders and new shareholders to reap the rewards. That’s the base from which Northern Bear can build a medium-term buy and build strategy to get the group to a more appropriate size, if that is the plan.
I see a lot of risk here, but I see a path to a great return, too.