RSM Tenon (TNO)

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.

6 Replies to “RSM Tenon (TNO)”

  1. Andrew Campbell

    Tenon has grown mainly by acquisition, hence the £73.3m of net debt at 31 December 2010. A company with a P/E of 5 with no debt and a pile of cash is worth alot more than a company with a P/E of 5 and £73.3m of net debt. I could start a company, borrow £100m, buy £100m of property, the property could fall in value to £50m, the market capitalisation of the equity in my company might be £1m and I could be making £1m profit after tax after servicing the debt. That company would then have a P/E of 1, it doesn’t mean it’s cheap. You have correctly picked up on Tenon’s habit of continually reporting exceptional costs. What this means is Tenon don’t make much for their shareholders over time by buying companies, they had just £19.2m of retained earning in their Balance Sheet at 31 December 2010 compared to £103m of share capital raised from investors. Empire building makes more money for Directors than for shareholders as your comparison of the value of Andy Raynor’s shares versus his remuneration package illustrates. Gullible shareholders are funding Andy Raynor’s inability to accumulate wealth for them over time. Yes, Tenon is much bigger than they used to be but each shareholder’s slice of that bigger pie has shrunk. I am not sure why you say that RSM isn’t much off the size of Tenon, RSM was half Tenon’s size in term of revenue, yet Tenon paid as much for RSM as the market was valuing them at at one point. Good for RSM Bentley Partners, not good for Tenon shareholders. If Tenon’s share price trebles from here it will only be slightly above where it was before buying RSM. That could easily happen once exceptionals drop out and the economy improves, however, long term shareholders should consider Tenon’s continual inability to generate value and accumulate retained earnings in the bottom of their balance sheet. They might have a couple of good years and then they will be back to buying some other firm of accountants to justify bigger pay packets and investors will suffer another 50% fall in the share price until the exceptionals wash through. This is not a value stock, far from it, it is a value trap for investors who don’t appreciate the impact of net debt on a company’s value and it’s correlation with business failures. By all means buy out of favour companies with a P/E of 5, I try to myself, but make sure the company has net cash and retained earnings in the balance sheet, i.e. proof that over time they have generated a decent return after tax on the capital they employ. A £19.2m return cumulatively on £103m of shares issued over years and years of consoliding is abysmal, any true value investor would appreciate that.

    • Lewis

      Hi Andrew,

      Thanks for the comment.

      I see your points, and it more or less sums up the bearish PI mentality I saw when roaming around the internet, but I think it’s overdone. I’ll go through them and try to be fairly logical about it..:

      a) Firstly, on the issue of net debt, I don’t think it’s a particularly relevant metric for Tenon. As discussed above, a large amount of their capital is tied up in receivables – which the ‘net debt’ figure doesn’t account for. Not allowing for receivables only really makes sense if you think there’s no chance of them being paid back – and I have no reason to believe that. Historically they paid fairly low interest rates on their debt, a factor I suspect partly coming about from the fact that they do ‘have’ the money – in a sense – it’s simply tied up, with work rendered but without cash received.

      b) I agree with you on the overpaying for the acquisition – but from the point about the trebling of shareprice onwards, I can’t help but disagree. Whether or not the trebling in price is miniscule in historical terms or not is a completely moot point to me; all decisions I make investment-wise are made on the margin. Long term shareholders may well have been burned given the rather precipitious share price drop, but that shouldn’t factor into my decision. Saying a trebling in share price could ‘easily happen’ shoud make you agree with my decision; because it implies you think, at this point, the share is cheap. Where it was in 2007 makes no difference to that opinion.

      c) Finally, on the classification of ‘value stock’, I’d disagree with you again. As I said in my penultimate paragraph in the post, everything should be considered against the current price of the stock. A stock being ‘value’ or otherwise isn’t fixed in time – it fluctuates with the price. Cisco and Vodafone traded on triple digit P/Es in their early years as growth stocks, and they’re now considered by some to be value stocks. Obviously I’d love to buy stocks which all have oodles of cash on the balance sheet and piles of retained earnings, but their attractiveness usually makes them more expensive. The reason RSM Tenon is so cheap is precisely because it doesn’t have those two features, and I’m gambling because I think the next few years will be more positive.

      I can see long-term shareholders certainly being annoyed. I wouldn’t have bought at, say, 65p at the start of this year, though, because I don’t think it looks anywhere near as cheap at that price. There’s been little actual news since then, and the price has shed 60% of its value. Private investor sentiment has got more and more bearish as the price has dropped. I acknowledge the questionable decisions of management, I just think at the price I bought – 25p – those issues were more than priced in to the stock.

      On an aside, if you have any net cash companies with retained earnings that still look cheap on an earnings/assets basis I’d love to hear about them!

    • Lewis

      Hi Jamie,

      I agree the yield is rich – but the dividend itself being rich is a matter of opinion. It’s covered over 3 times in a business which requires few tangible fixed assets. A 6% yield is eyecatching, but it’s not as if that’s been hiked significantly recently – instead, a share that was yielding more like 2% saw a shareprice nosedive. I agree it all piles on the question marks, but I can empathise with a management decision to maintain the dividend given the rather hefty slamming the market gives you for cutting it – though given the negativity the stock faces anyway, I wouldn’t be surprised if they did cut. Seems as good a time as any.

      Your comment also highlights the ability of investors to turn anything on its head, though. Investors ask for more management commitment to returning cash to shareholders, more proof they’re not simply empire-building for their own profit. When the yield starts looking too attractive though, it raises questions of management competence given the liquidity issues. How can they win?

  2. Jamie

    Th reduction in dividend was pretty brutal, and the yield is back to a fairly low level, but it does look like a sensible management decision. The resulting relief on debt helps, and the share price is nosing back upwards, off-setting the dividend cut. I’m encouraged by the pressure now on the Big Four, which may shake some business from the tree. But I hope RSMT Directors aren’t spending too much of my much-missed dividend on meals at the Connaught.

    • Lewis

      Indeed. There are a lot of positive things that could happen in the coming few months with RSM; though I suspect the price will only really recover when the whole issue around the distrust of management is sorted out, however that me be. Perhaps it’ll be a long healing process. Either way, I think it’s priced to make taking that punt attractive enough. As you say though, the risk of a rights issue to fund oysters, champagne and board meetings aboard luxury cruiseliners does still look to be present!

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