Airea falls at last hurdle

Sunk by the F_Score

The process of researching carpet manufacturer Airea has felt like death by a thousand cuts.

What started as a promising looking investment now leaves me feeling a little frustrated. The company is extraordinarily cheap according to the net current asset value calculation, one of the most demanding in the value investor’s toolbox, but an even more exacting and potentially more precise (but still approximate) calculation, suggests it’s trading around liquidation value.

Although not as cheap as I hoped, the price is very attractive if the company is still viable. So it passes the valuation test with two important caveats.

1. Airea has a large defined benefit pension obligation, which could mean large movements in the currently relatively small deficit, which in turn would make a mockery of the valuation.
2. I have to be confident Airea has a profitable future.

To pre-empt fellow blogger Mark Carter (aka Blippy), who likes to do this (metaphorically), if you put a gun to my head I still think the odds are Airea is a good investment.

The directors seem to be doing their best to control costs, although they can’t do much about the price of yarn and synthetic fibre, they’re revamping the range, and they’ve invested considerable sums themselves in the company.

But in managing the Thrifty 30, I aim to put safety first, and I’m not confident enough in its future earning power to stake the portfolio’s virtual money on Airea.

Even what looks to me like a consistently well financed, and well managed manufacturer, Victoria, struggles to generate decent returns in the carpet industry so it’s a very tough business.

And the final cut, the one that’s tipped me from being confident enough, to not confident enough, is Airea’s recent trading performance as viewed through the prism of the F_Score. Here’s the spreadsheet:

A middling F_Score of five out of nine isn’t catastrophic, but Airea only just made a profit last year, and in cash terms it made a loss. That tips the balance, because cash pays the bills.

Deducting net capital expenditure, money spent on increasing the capacity of its dye house and investment in new carpet ranges, and the free cash flow loss is over £700,000.

Putting safety first means identifying where things could go wrong and deciding whether the risk is significant. Broadly speaking two things can go wrong with any investment in a company.

1. The shares can be too expensive, driven up by investors unrealistic expectations. Although that’s most unlikely to be true of Airea, any valuation of the company is speculative because of the uncertainty introduced by the pension fund.
2. The business can be broken, and while I don’t think Airea is broken, I’m not confident in that judgement.

As I said to the ever so slightly mad Professor Professorson in the comments section, investing means compromise.

Bulletproof businesses at bargain prices don’t come along very often, maybe once or twice in a career. The rest of the time we’re looking for companies that are cheap enough, and strong enough and researching Airea has chipped away enough of my confidence to leave me unsure as to whether it is.

If it was recovering more strongly, this blog would have a different conclusion.

That leaves Victoria. I’m taking next week off, but will probably add it the portfolio when I’m back.

I’ll also be deciding on publisher Bloomsbury, which will have published its half-yearly results by then, and IT distributor Northamber when it publishes its annual report.

TTFN.

Correction: Airea not trading below liquidation value

Oops! I did it again

B0#0cl<$.

There’s a mistake in Airea’s liquidation value worksheet (published last week). The equation for adjusted net assets only deducted current liabilities, when it should deduct all liabilities. It’s all very well blaming misbehaving formulae but I type them in, so I’m sorry about that.

The upshot is floored carpet manufacturer Airea is not trading at a 19% discount to estimated liquidation value as I reported, It’s trading at a 4% premium.

That’s still extraordinarily cheap if the company’s viable. It’s 35% below net current asset value, and 66% below tangible book value. You really have to take a very pessimistic view of the value of Airea’s assets to come to any other conclusion.

But before I present the revised spreadsheet, there is another caveat.

Two readers, Trident and Jeremy, say I should account for the pension obligation in the valuation. In one sense I have, the deficit (the difference between the value of its obligation, and the value of its assets, which is just over £1m) is included as a liability and deducted from the asset values used to calculate liquidation value, net current asset value and book value.

The problem, though, is the size of Airea’s defined benefit pension obligation. In common with many established and contracting businesses, it’s big. I can’t say exactly how big, because details of the pension fund were not published in the preliminary results, though they will be in the annual report.

Last year, though, Airea’s pension obligation was just over £40m, bigger than the company itself, which has total assets of about £25m and sales of about £29m.

A big pension fund attached to a small company is like a giant fly-wheel attached to a rather rickety machine. When it’s running smoothly everything’s fine, but a small hiccough can unbalance everything.

Although we don’t know the size of the pension obligation, we do know the deficit, the difference between the value of the fund and the size of the obligation has come down since last year, from £5.5m to £1.2m because the government has changed the inflation measure used to determine index linked retirement benefits.

This time, changes in the many complex assumptions used in calculating Airea’s pension obligation have worked in the company’s favour, but the dramatic effect it has illustrates the problem with large pension funds.

If Airea’s deficit this year was the same as it was last year (nearly £6m) the company wouldn’t look nearly as attractive an investment. It would be trading at a 37% premium to net current asset value, and in terms of estimated liquidation value, there would be very little value left.

So, unfortunately, the pension fund is another factor that reduces the certainty of the valuation, and my confidence in it.

Here’s the revised worksheet, with the correct liquidation value and the current pension deficit:

I’ve rearranged the bottom section to show the discount or premium the market price offers in comparison to each valuation measure.

Airea is trading below liquidation value

CORRECTION: There is an error in this article. Airea is trading at a 4% premium to estimated liquidation value!

Carpet manufacturer at 19% discount

The net-net calculation used by the Bargain screen to find the very cheapest companies is an approximation of an approximation.

Inventing it, Ben Graham reasoned that some current assets, the only assets Graham considered sufficiently liquid and easy to value, would fetch less than the values recorded on the balance sheet in a closing down sale. Using book values as a proxy for liquidation value would overvalue the company somewhat.

On the other hand he ignored fixed assets, property, plant and equipment, which would probably have some value, however uncertain, if the company was no longer a going concern. The over-valuation of current assets would cancel out the undervaluation of fixed assets and, as a crude measure, net current asset value would do.

A potentially more accurate, but still approximate estimation of liquidation value can be achieved by reducing the value of current assets and accounting for the value of fixed assets using the pretty arbitrary multipliers in the worksheet below (% of BV column):

Since Airea has yet to publish it’s annual report and doesn’t break down property, plant and equipment in its preliminary announcement, I’ve assumed a similar split as last year between property, which is valued at 50% of book value in this calculation, and plant and equipment, which is valued at 10% of book value.

The share price is 35% below net current asset value, an approximation of an approximation of liquidation value, and 19% below liquidating value, an approximation!

That’s unusual for a profitable company.

Caveats:

1. Airea is committed to nearly £5m of rent payable under non-cancellable operating leases on property and vehicles. Arguably I should have added the leases as an asset and a liability in the worksheet (which, arguably, companies should include on their balance sheets). If Airea had to sell the leases, there’s no guarantee it would get full price, so I’d have to apply a multiplier to them as with the other assets, bringing down the value of its assets in a liquidation. On the other hand, I’ve ignored a deferred tax asset of nearly £1m, which, assuming the company remains profitable should increase the company’s profit in future, and its valuation now.
2. Airea shares are illiquid, the mid price is 11.5p, but an investor buying in today’s market would probably pay closer to 12.5p. That reduces the discount to liquidation value to 12%.
3. This model ignores some costs that would almost certainly have to be paid in an actual liquidation, redundancies for example, so I’d hesitate to rely on it were a company actually liquidating.

Using liquidation values requires less guesswork than forecasting future profits, but beneath the surface there’s still a fair bit of fudging going on.

Nevertheless, Airea has passed this test. Providing Airea remains a going concern, I can say with some confidence it’s in bargain territory.

Carpets, not curtains, for Airea

This is what a bargain looks like

Look down at your office floor and you can probably see this (above).

Perhaps I’m not being fair to the carpet industry, picking a grey Burmatex to illustrate my first thoughts on carpet manufacturer Airea. But grey is how I feel about the carpet biz, like most investors probably.

We have every reason to be repulsed though, not bored, by Airea, which has, if you will excuse the pun, been through the mill. As Sirdar, the name it sold with its knitting yarn business in a management buy out in 2007, it frequently graced value screens, only to reappear even cheaper.

For the share price, the rot has never really stopped, but I’m wondering if, after years of rationalisation, mill closures, and asset sales, what’s left of the underlying business is viable.

According to the headline results the company has been profitable in its last two financial years and if that remains so, I don’t think the shares can get much cheaper. According to the bargain screen the shares cost just 0.6 times net working capital, a statistic I will confirm in another post soon.

Airea manufactures tufted carpets and carpet tiles for the commercial market under the Burmatex brand and the residential market under the Ryalux brand. While investigating Victoria I got the impression tufted carpets are cheaper to manufacture than Wilton and Axbridge, and therefore more likely to make up the value end of carpet retailers’ ranges, but Airea claims some innovations of its own, like bespoke colour matching.

The 2011 annual report has yet to be published, but in September’s preliminary results chairman Martin Toogood talked of sustained suppressed demand, particularly for residential carpets, which has been the refrain for some years now.

Judging by the blurb in successive annual reports Burmatex, used in offices, shops, schools, and hospitals, seems to be keeping the company in profit. Despite rationalisation and investment in Ryalux, cost cutting and efficiency gains have not been enough to offset a huge decline in residential demand. Sales fell from £28m to £13m in round numbers (red bars) between 2008 and 2010.

Total sales fell another £2m to £29.0m in 2011 according the preliminary results. With contract sales in line with 2010, the contraction was limited to the residential market as the company continues to withdraw unprofitable products.

Still, this year the company seems to have halted falling sales in the contract market and slowed the falls in the residential market. The worrying line in the chairman’s statement, if, as we are led to believe, government cuts are just beginning, is this one:

Strong deliveries against major retail store refurbishment programmes and public sector new build projects compensated for weak demand in the general maintenance and refurbishment market.

If this year Airea was saved by government spending, what happens when there’s nobody left prepared to spend? It is, of course, a problem faced not just by Airea, but vast swathes of the economy.

That’s the gloomy bit. And it’s supposition, against which I can lay some rather more concrete facts.

Subject to checking the finances, Airea looks like a recovery situation. It’s been cutting costs, selling assets and revamping its product. It’s very cheap. It’s returned to profitability. And it has new management, who are committed to the business.

Chief executive Neil Rylance, who joined in 2008, has built up a 5.5% stake, and chairman Toogood (moved up from non-executive director in 2009) has a 4.5% stake, both buying significant quantities of shares in April and June this year. Finance Director Roger Salt has also bought a modest number of shares this year.