Zirax double-up

I more than doubled my Zirax stake today. I had wanted to buy at 11p, but had no spare cash in my dealing account. By the time the money was there it was up to 12p. I hummed and hawed and decided to go ahead anyway, because otherwise I'll kick myself if it goes back up (and I think it's good value at 12p, just like I thought it was value at 14p when I first bought).

ZRX - Zirax - 28/4/08 - 12p - 4.8% of portfolio, for a total of 9.6%, at purchase price. At current prices Zirax is now 8.7% of my portfolio.

So why do I like Zirax?

Value

• I think a fair P/E multiple is about 12.
• I estimate earnings in 2 years time at about £2.9m purely based on the imminent increase in capacity. I'll put it at £3.2m to include input from acquisitions and economies of scale. That equals 1.9p per share.
• That puts a fair value in 2 years as 23p.
• If I'm looking for 20% annual return, that makes it good value at anything up to 16p.

Diversity

• I don't have any other industrial shares, and I think Zirax adds some nice diversity.
• I think it should be recession-proof, unlike MXM, BDI, RBS, TW.

Concerns

• Zirax is tiny, but hopefully that will change over the next few years.
• There is a bid/ask spread of 1p, so about 10% at current prices. Ouch. If it stays at 1p and the shares double in price, it will be slightly less punitive.
• Most of its sales are in the Russian market, but it should be increasing its geographic diversity now its factory in Italy is coming online.
• A lot of the shares are controlled by insiders. That can make things difficult - they can essentially manipulate the share price to suit their own interests (if they want to take Zirax private they could drive down the price and buy out the other investors).

All in all, I'm pretty bullish about this little company. I think the shares are being held down by sustained selling from Pennygold Trading Supplies, who are one of its biggest shareholders and seem to be getting out completely.

Performance
Here's an update on my portfolio performance. Marginally profitable once future dividends are taken into account.

Taylor Wimpey

TW - Taylor Wimpey - 24/4/08 - 130.6p - 9% of portfolio
New purchase today: Taylor Wimpey at 130.6p. I first looked at this at 151p last month, and was in two minds. I wanted to wait until the new tax year, but by then it had gone up, so I held fire.

Last night I adjusted my valuation downward because I've become more pessimistic about the future of the UK housing market, but still thought fair value was 215p. Yesterday they closed at 145p - a discount of 32%. I decided to take the plunge. By the time I got into work they were 135p. I checked the news - some negative noises from Persimmon, but nothing my valuation didn't take account of. By the time I bought it had hit 130.6p - a discount of 40% - perfect.

Once the housing market has crashed and is on the way back up again, Taylor Wimpey will be well placed. They've had practise coping with a crash in Spain and now the US, so hopefully they've got a good strategy worked out by now. They have a lot of debt, but this is secured on their monster land bank, so unlikely that this will cause them too many problems - I think they should have sufficient cash flow to reduce their debt over the next few years, even if they're not profitable.

After a few years of zero profit I expect TW to return to significant profit. In the meantime I think they can maintain cashflow by depleting the landbank - and a lean period of trimming costs will be no bad thing for the long term.

Hopefully the US market will begin to recover while the UK market is still in recession, so that diversity should help.

Upside
In a few years things should look very rosy.
Price to book value is extremely favourable. TW account for land at cost price, and they've held a lot of it for a long time, so it is probably even better than it appears.

Downside
It's going to be tough in the meantime. I may prove to have bought too early.
I expect the dividend to be cut or eliminated altogether for a couple of years.
Net debt of £1.4bn is too high for comfort. Would be nice if this was significantly lower to allow them to increase the landbank when land is cheap.

Future
Here is where I'd like to see the company in 5 years:
Earnings £400m after tax, EPS about 38p.
Net debt £1bn.
Dividend 20p.

At a P/E of 12 and a 4% yield, that means 456p per share for a 250% profit - an annual return of 30%, not including dividends. That would be nice :-)

Portfolio
Here's my portfolio breakdown at current values:

Finance: 28.7% (RBS)
High yield ETF: 21.9% (IAPD: 11.1%, IDVY: 10.8%)
Builders: 9.7% (TW)
Emerging ETF: 17.0% (IEER: 5.3%, LTAM: 6.1%, IFFF: 5.5%)
Chemicals: 4.4% (ZRX)
Software: 18.4% (BDI: 3.5%, EDD: 5.9%, MXM: 9.0%)

Star performer: LTAM up 20%.
Biggest dog: BDI down 30%.

Zirax went up to 12p before I could buy more at 11p... I'm hoping it will go down again.

RBS Rights Issue

So, RBS will be doing a rights issue. Hmm... that wasn't really what I was hoping for, but I could have got out with a significant profit yesterday morning. I didn't, so lets look at the reasons why. But first, let's see how wrong I've been over the last few months...

My mistakes
My first purchase was made before I really understood the company, and I didn't leave myself much of a margin of safety. I've read Ben Graham now, so hopefully not a mistake I'll be repeating.

Here's why I first bought at a smidge under 400p:

• "The history of strong dividend growth" - which will now suffer a "discontinuity" in the carefully chosen words of Tom McKillop.
• "A P/E of less than 6" - doesn't help if (a) you have to issue more shares, and (b) your earnings are going to suffer.
• "the banking crisis is unfairly dragging down the share price". Remove the word "unfairly" and I was right :-)
• I listened to Fred Goodwin in his analyst presentation in December, and he was pretty positive. Bad move.

I recognised the potential downsides:

• "If RBS have to write off a load of bad debt, they may be forced into asset sales, cut dividend or rights issues. If the economy falters or further problems hit the banking sector, then the entire sector will suffer."

Asset sales, check. Cut dividend, check. Rights issue, check. Hmm... at least they didn't go bust.

My second purchase

Some time later I made my second purchase at the ex-divi price of 305p (just after Bear Stearns were bailed out). At that point my risk-weighted valuation of RBS was £50bn. I was confident that RBS would not be a wipeout, but recognised that it would almost certainly suffer.

The current position

So, where will I be post-rights? RBS are paying the final dividend in cash, so that's 23p off my initial purchase price of 399p. So 376p for that purchase, and 305p for the second. That makes an average of 348p. The rights issue is at 200p on an 11 for 18 basis - that's 122p per share. So adjusting for dilution I have effectively paid 470p per share (on the basis of the current 10bn issued shares).

Now, what are these adjusted shares worth? My risk-weighted expected earnings will increase. I was previously factoring in the possibility of a 10% complete wipeout chance, and the dilutive effects of a rights issue. On the other hand, the credit markets continue to deteriorate, so there are other factors to weigh up.

My latest estimated earnings were £4.6bn, and I thought a fair P/E was 10, so a market cap of £46.3bn was reasonable. That was accounting for a rights issue as an effective drop in overall earnings rather than a dilution.

I now estimate £5.35bn earnings (on the same basis). So I put a market cap on the post-rights-issue RBS of £53.5bn, and a fair share price of 535p (including payment for rights issue). Still above the 470p that I am effectively paying... I wouldn't buy more at that price, but I'm happy to hold.

Adjusting back for the extra 122p rights issue contribution, that puts a fair value in the current market of 413p. As of close of business today, the share price is at 345p. I spurned the chance to sell at just under 400p.

So, at what price would I buy more or sell? I will buy more given a discount of 40% to fair value (I like the long-term prospects but I already have a lot of this share so am not keen to increase my holding) so 250p. I will reduce my holding at fair value, so about 410p. I will sell out completely at fair value plus 10%, so 450p. All of that assumes no significant change in operating conditions. At 345p I'm holding and watching.

Zirax preliminaries

Preliminary results are out for Zirax. Profit is around £1.9m (declared in dollars, converted at a rate of 2:1). My prediction was £2m, so pretty close. The extra capacity at Rosignano is coming onstream and should be up to capacity in the next few months. Since this won't fully contribute to a year's earnings I will revise my estimate for next year's profit down to ~£2.5m, and £3.2m for the year after.

Shareholder's equity is £15m, compared to their market cap of £18m, so trading pretty close to book value. There's been a worrying movement of working capital, but apparently that's just due to the timing of the Moscow City Council contract, so should unwind next year. Once that's happened Zirax should be highly cash-generative. I think there's a lot of scope for acquisitions, especially if they can use earn-outs and deferred payments to minimize short-term costs. The purchase of Solith sounds like a good start.

The full report should be available tomorrow, so I look forward to reading that. Given the currently depressed share price I'm considering adding to my holdings. Zirax seems a very solid little company and provides some nice diversity to my portfolio.

I do still have some concerns:

• Zirax is very, very small.
• The shares are thinly traded and there is a fearsome bid/ask spread.
• The Moscow City Council contract is a large part of their revenue, and currently 80% of their revenue comes from Russia.

I think these are outweighed by the qualities of the company:

• Great forward P/E of less than 6 on my estimates.
• Good growth prospects beyond that from acquisitions.
• No debt - a pile of cash in the bank to fund expansion.

It might take a while for this company to get noticed, but it's bound to sooner or later.

Maxima

I recently dipped my toe in the market again and bought some shares in Maxima. This will probably be my last AIM purchase for a while - I can't hold them in an ISA and the next financial year is just around the corner, so I need to think about what will go in the ISA.

MXM - Maxima Holdings - 2/4/08 - 146.5p - 11% of portfolio
Maxima is an acquisitive software company, and has a good record of buying smaller companies and integrating them. It also does some of its own R&D.

Many of its acquisition targets are relatively cheap in terms of P/E. Maxima bought a lot of them using its own shares when they were double the price they are now - making it even more of a bargain when I can buy shares at their current depressed price.

Once they acquire companies they aggressively cross-sell, which saves them a lot of time and money in seeking out new customers.

The thoughts of a UK recession are weighing heavily on the share, but I think things are way overdone. The directors agree with me - they topped up big-time at roughly the same price. I think there might also be a lot of sellers out there who received Maxima shares when their company was purchased. The disparity between buyers and sellers is causing a pretty favourable price.

Maxima has a P/E of just over 10, but if you take out amortization (which I think gives you a truer picture) this is actually 7.5. Cash flow is therefore very strong. They have some debt, which is a shame, but not enough to be concerning in itself. What is does mean is that large further acquisitions might have to be curtailed - paying in shares would be unfortunate given the current depressed share price. A period of consolidation might be no bad thing, and I think Maxima can achieve decent organic growth. They can fund a few small acquisitions just out of cash flow.

One last thing: they pay a pretty good dividend for such a small company. Yield of about 3.6%, covered many times over.

All in all, pretty tasty.

Downside: Recession could hurt earnings for a while. Debt and depressed share price could curtail large acquisitions.

Upside: Continued earnings growth & dividend growth will surely make this a star share once a recession has been and gone.

Outer: I don't want to get out, I want it to make me rich. I'm going to drop this field from my reports, because I'm not planning to sell any shares unless they're ridiculously overvalued.

Summary
Here's the breakdown of my portfolio based on current prices:
Emerging ETF: 17.5 (IFFF, IEER, LTAM)
Chemicals: 4.3 (ZRX)
Finance: 33.5 (RBS)
High yield ETF: 23.6 (IDVY, IAPD)
Software: 21.1 (BDI, EDD, MXM)

BDI and ZRX are the dogs of portfolio so far, down 24% and 22% respectively. The ETFs are all up to a greater or lesser extent. If Zirax weren't so thinly traded I would think about buying more, but I don't like the idea of the market maker taking 10% on every trade.