Martin Conlon, Head of Australian Equities – Schroders
A2 Milk has posted great results with an almost 50% increase in revenue, but it strengthens the perspective that many valuations of businesses remain disconnected from whatever levels of cashflow are evident. It’s as if a bunch of birds in the bush are better than one in the hand.
Trends across the developed world in recent decades have seen business investment progressively migrate towards intangible investment and away from traditional fixed asset investment. Equity investors are increasingly exposed to assessing the value of profit streams that stem not from ownership of fixed assets, but from a broad spectrum of intangible assets encompassing software, R&D, brand names and patents, among others. Many of the larger stock price moves over the month were in such businesses.
The necessity to improve our understanding and ability to value this type of business is obvious. The topic is explored in an interesting book, Capitalism Without Capital — The Rise of the Intangible Economy, by Haskel and Westlake. Understanding the nature of intangible assets helps explain how they have been the source of some of the world’s most successful companies; however, it also highlights some of the challenges for investors in valuing these businesses. They refer to the four characteristics of intangible assets: scalability, sunkenness, spillovers and synergies.
Scalability is undoubtedly one that has firmly captured investor enthusiasm. When a company’s competitive edge stems from an intangible, the prospect of reselling it millions of times over without the cost of associated physical infrastructure is alluring. While the likes of Google and Facebook will always be popular examples, the likes of REA and Carsales domestically have done a phenomenal job of developing valuable intangible assets and the prospect of potentially delivering scalability internationally remains alive.
Sunkenness refers to the tendency of intangible assets to often have little in the way of recoverable value if they are unsuccessful or expire. Given the spate of biotechnology takeovers of recent weeks, one could be forgiven for assuming that there is an entitlement to recover multiple times the level of R&D investment regardless of efficacy, however, in more normal times, sunk cost may not be recoverable to any degree. Importantly, this risk has significant implications for the financial structure of a business, as banks are traditionally more comfortable in areas where recoverability is solid.
Spillovers refer to the ability of intangible driven companies to take advantage of the ideas and efforts of others, while synergies reflect the ability to combine them with other intangible or tangible assets. Apple products, for example, would probably be a touch less ubiquitous without the existence of wi-fi and cellular networks.
These characteristics and the areas of competing, investing, public policy and financing in the intangible economy are explored in the book, however, our observations of the share prices of intangible driven companies together with an examination of the research of many of the analysts’ purporting to value them, would suggest that while intangible assets have the potential to support many outstanding and durable businesses, valuation of them remains less than scientific.
As is the case in the valuation of any asset, the quandary lies in the extent to which the long-term value of an asset should change in response to an incremental piece of information. Many of the currently popular intangible-based businesses have small or relatively small revenue lines, relatively high margins (implying a small cost base) and valuations that are large in comparison. Results season obviously provides a periodic snapshot of progress, however, as price reactions increasingly gravitate to the incremental, reactions often seem to us to be laughably disproportionate. That a few million dollars of additional revenue can give rise to hundreds of millions or billions in value seems astonishing. Growth rates must surely become somewhat meaningless when the base is very small. Apparently not.
The standout example this month was again A2 Milk (+47.5%), NZ$437m in revenue and NZ$98.5m in profit for the half reflects the success of management in capitalising on the Chinese market and translating the intangible value from patents and brand into sales. However, when revenue surpasses expectations by somewhere around NZ$20-$30m, the addition of more than the $3bn of market value (or about 100 times the revenue surprise) seems aggressive. Similar observations could be made in the case of Cochlear (+5.9%), where $35m of revenue growth over the same period last year and a $4m increment to half yearly EBIT, taking the total to $160m managed to drive market capitalisation up another $500m and past $10bn; and Next DC, where revenue and EBITDA increments of about $2m (total full year revenue is expected to be a little over $150m and EBITDA about $60m), saw market capitalisation up another $100m or so, moving close to $2bn.
The comparisons to more traditional businesses are stark. In supporting a market capitalisation similar in size to A2 Milk, Qantas (+11.8%) generated an additional $476m revenue versus the same period last year and earned a pre-tax profit of $976m for the half year. Alumina (-2.5%) earned EBITDA of more than $US1.6bn, NPAT of $US340m for the 2017 full year offering investors a 7.5% fully franked dividend yield, almost no debt and supporting a market capitalisation of $6.5bn. $226m in EBIT for the half year induced a reduction in the JB HiFi (-8.4%) market cap of more than $200m, driving a market value of around than a third of A2 Milk, despite markedly higher earnings.
Working in the real world is not offering quite the same market valuation awards as the intangible one. The attractions of ‘scalable’ intangible assets are obvious, however, the future expectations and valuations attributed to many, appear fanciful to us. It would appear we should rewrite the old saying: ‘A bird in the bush is worth 2 or 3 in the hand’. Valuation aside, the shift towards intangible businesses raises a host of further questions: Why do these business list, given a lack of need for capital? Why do investors believe they have an indefinite right to future profits given they have contributed neither ideas, intellectual property or capital? Will a shift toward intangible businesses deliver an economy with structurally higher profits or are physical asset businesses expected to accept lower returns? While we struggle to answer these questions, it seems illogical when valuations offer no margin of safety against what are, in many cases, greater levels of future uncertainty than those facing physical asset companies. Our question in investing your money is invariably the same. If we were buying the entirety of the company with our own money at the current market price, would we be comfortable buyers? In the case of most of the market darlings in technology, healthcare etc., the answer is no.
Despite our concerns over valuation levels in many sectors, results season offered no cause for extreme pessimism on the ongoing profitability of most sectors. Buoyant commodity prices and recovering energy prices supported very solid results from resource-based businesses, while banks continue to show no signs of either significant margin erosion or deteriorating bad debt experience. We continue to believe that a sensible valuation approach to these sectors should expect profitability levels lower than those currently being delivered; however, every year in which better than anticipated profits prevail offers investors some insulation from the potentially tougher times ahead.
The pre-occupation with earnings momentum continues to drive what we see as generally disproportionate reactions to positive and negative news increments, with little attention being paid to the far more important relationship between the prevailing market valuation and a reasonable expectation of sustainable profits. Investing on the basis of expected capital gain through ‘passing the parcel’ to someone else is undoubtedly taking precedence over a careful consideration of the dividend stream a business is likely to provide. As signs of inflation emerge in some areas and pressures build on the role of ultra and artificially cheap money in the global economy, it would seem logical from our perspective to temper the cavalier attitude to risk which has prevailed over recent years.