A cashflow drought
RSM Tenon have been in my portfolio since inception, and have fluctuated wildly in that time – having bought at 25p per share, within a few weeks they’d risen 35%. Since then, they’ve trended down and now sit at around 28p, 10% up on my original price and still very much a feature of my portfolio. As in Zetar’s case, the rise shouldn’t put you off purchasing, as there has been news since my original buy that improves the complexion of the group; barring an unforeseen hiccups or big jumps, I won’t be selling any time soon.
RSM Tenon are one of the top ten accounting firms (by revenue) in the UK, formed by the acquisition of RSM Bentley by Tenon Group in late 2009. They’re also growing rapidly – it only takes a quick glance at the chart to the right to see that they’ve been moving fairly quickly, and management have said that revenues will be circa £250m this year – another impressive jump, largely due to acquisition activity. Growing shares never trade on P/Es of 5, though, and so understanding the warts and the issues holding RSM so deeply in value territory is important.
I’ve pointed to one in the title, but we’ll come back to that later. More logical to begin with, as we admire the curving upward slopes of growing profits, is the question of whether their account of their profitability is actually fair. As with most companies, RSM Tenon exclude a number of items from their statistics when speaking of profitability – usually items classed as ‘exceptionals’ or the amortisation of intangible assets. This is done to allow investors a more accurate look at the company – if a company spends £10m on integrating a new business, for instance, that has to be recorded on the income statement. But given that it’s unlikely to happen next year (unless they acquire again!) investors are often more interested in the results underlying that, which give a better picture of future trends – my graphs always use underlying statistics for that reason.
Last year, though, RSM reported £13m of exceptional costs – a figure that cut their profit by over three quarters. The year before that, they reported £4.3m – a third of their headline profits. In the interim management statement this year, RSM have already reported £8.8m of exceptionals cutting into their £10.1m ‘underlying’ profit. Such recurring exceptionals try investors’ patience, as the longer they continue the less ‘exceptional’ they look – and if I were to consider them to be likely to recur, my graph above would look very different indeed. Instead of trading on a P/E of 5, RSM would trade on a P/E of over 20. The graph below left shows the problem. The difference between those two lines is £30m – or roughly half their net profit over the last 6 years.
It is far from doom and gloom, though, despite my rather downbeat portrayal above. The company does have a decent reason for heavy exceptionals – the aforementioned acquisition of RSM Bentley, a company which isn’t hugely off the size of Tenon itself. Integrating two large companies is far from simple, and exceptional costs should be expected. The company also reckons they’ve engineered £10m of cost savings next year and into the future from the exceptionals this year – which, if true, is a reasonable price to pay for a far more efficient group structure. Still, I would’ve hoped for a slow down in exceptionals, not a colossal £8.8m in the first half of this year.
The chart above right highlights the other big issue facing RSM Tenon – cashflow. Cashflow statistics sometimes fall by the wayside in investment decisions, as earnings often represent a better yardstick. Cashflow is far more volatile, as we see, as it can be altered by all sorts of subtle timings in how and when the company is paying creditors and receiving payment. Accounting earnings, then, tend to be more prevalent. In RSM Tenon’s case, though, cash flow is an issue that’s impossible to overlook – mostly because of the last two years, where operating cash flow sat in negative territory while the company is booking record underlying paper profits. Part of the problem is the big exceptional bill as already discussed, but that’s not the end of it.
The balance sheet cuts to the bottom of it – a ‘trade and receivables’ line in the interim management statement that came to £91m, or more than a third of their expected full year revenue. It’s this that causes the group to carry £68m of net debt – their working capital is locked up in wasteful, unusable receivables. While net debt is slowly on the way down, according to the pre-results update – and an improvement in the working capital cycle saw lock-up reduce from 105 days to ‘less than 100’ – less than 100 leaves me rather dubious of any big changes, as 99 could simply be noise in the statistics. Once again, though, things slowly seem to be improving. The renegotiation of their banking facilities should be viewed as a positive as it’s a recent vote of confidence in the business, suggesting that the problems they are facing are simply ones of liquidity. The group looks to have headroom of around £20m on those facilities, which isn’t particularly large – but that may well be viewed as a good thing by shareholders tiring of the consistent trail of acquisition and big exceptional cash costs!
All of these issues have left investors sceptical of management intentions – on my usual run-round of internet message boards, there was certainly a degree of antipathy towards the management. £2.7m spent last year on director emoluments is hardly a small bill for shareholders to foot, and it’s no surprise that the large swathes of director share options are based on ‘adjusted’ earnings per share – i.e., before the exceptionals I’ve discussed above. Directors do own a reasonable number of group shares, but against the large salaries it’s not a completely positive picture – CEO Andy Raynor, for instance, holds shares worth roughly £550,000 vs. a salary, bonus and pension plan last year summed at £896k.
After all this, though, I’m acutely aware I sound like a raging bear on the company. I suppose that’s a good time to drop in my fundamental point, then – everything I say about the business should be considered against the current share price. That’s a point I cannot stress enough, and I think it’s a common mistake. Many companies which are swarming with unattractive features make good investments – and often shining examples of exemplary business practice just don’t make sense at the price they’re trading at. At about 28p a share, RSM Tenon are very cheap, and even given everything I’ve said, I’m more than willing to put my portfolio’s cash on the line at the price being offered. It’s certainly not a risk free investment – the tangible book is negative, so I have to attribute considerable value to RSM Tenon’s competitive position and history, and they’re far from through the issues discussed above. Underlying all of that, though, is a company forecasting £250m of revenue this year, which has historically earned around 10% operating margin – on an upward trend with scale. Interest costs remain relatively low. It’s not far-fetched, then, to talk about a £25m underlying operating profit this year, feeding through to around £16m net profit. If exceptionals were to be done with in the next few years and the £10m of cost savings come through, the company would look exceedingly cheap – even if they don’t grow.
The range of outcomes for the next few years for RSM Tenon is certainly wide – any number of things could happen, even more than with most companies, and investor sentiment could change at any point. It’s ugly, it’s disliked, and it has its fair share of problems – but those are the factors that allow me to jump in at a price that looks so cheap on balance. It may be a riskier punt that some of my other picks, but I still feel RSM Tenon offers value.