Capitalisation of development costs

One thing that irks me about IFRS vs GAAP is the way that software companies can capitalise their development expenses. This can give a very misleading picture of the financial position of a firm, and in extreme cases make the headline profit numbers entirely misleading.

This recently came to my attention while looking at ACS, which isn't even a software company, which managed to make an accounting profit of £2.5m, almost entirely comprised of capitalised development expenses. They had not previously capitalised any development expenses, so had negligible amortization to counterbalance the development costs.

I tihnk the key thing to be careful of is when capitalised development expenses far outweight amortization. In that case the profit will be far higher than cash flow, and the firm may need to borrow or issue shares to survive. On the flipside, if amortization far outweighs capitalised development expenses it may indicate a highly acquisitive company - needing to buy other firms to grow, but with the potential to scale back in a downturn and simply generate large amounts of cash.

Let's look at my 3 firms.

Bond International Software

2008

Profit: £2011m

Capitalised development expense: £2788m

Amortization: £2576m

Free cash flow: £1799m

2007

Profit: £3645k

CDE: £2849k

Amortization: £1883k

Free cash flow: £2679k

Conclusion

Bond largely grows through internal development, so it is reasonable that their profit exceeds free cash flow. Their free cash flow is still very healthy.

At a current market cap of £21m (at 65p) they certainly don't look expensive.

Maxima

2008/2009 (guess)

Profit: £3m

CDE: £400k

Amortization: £4m

Free cash flow: £6600k

2007 / 2008

Profit: £3745k

CDE: £430k

Amortization: £3410

Free cash flow: £6725k

Conclusion

Stonking free cash flow. They grow through acquisition, so you would expect cash flow to exceed profit, but a solid free cash flow is a huge advantage if the market turns against them. Compare their market cap of £21m to their free cash flow of £6m+ - they look very cheap indeed. They do of course have some debt - about £17m worth - so maybe not super cheap, but definitely cheap.

QDG

Free cash flow doesn't look too pretty, but £7m of cash means that at least they can ride out the bad times.

GSK + portfolio maintenance

Bought GSK this morning at 1052.25p, top-sliced Barclays and reinvested the proceeds in MXM. I accepted the TW open offer yesterday. Time to leave my portfolio alone for a while.

BATS + NG

Per my earlier post, I've made a modest investment in BATS and NG. Money transfer delays mean GSK will have to wait until later in the week. I plan to make a similar investment in GSK, and then in a few months double my holding of each (depending on prices).

British American Tobacco and National Grid now each form ~3% of my share portfolio.

A back of the envelope calculation suggests the yield on my portfolio is about 4.5% (taking appropriate account of dividend cuts and cancellations). Not bad, considering my mortgage is 1.24%.

Cyclicals vs defensives

The premium commanded by defensive shares over cyclicals seems to have disappeared over the last couple of months. Since the beginning of March, Greene King has advanced by 27%, Next by 30%, Taylor Wimpey by 150%, and the banks by up to 200%.

On the defensive side my portfolio has some bonds (heavily weighted towards banking, so not that defensive - up 9% since March), Diageo (17%) and Tesco (9%).

I'm not ready to sell out of my cyclical shares yet - I still think they're below fair value - but I think my next investment will be into some more defensive shares.

I'm looking at British American Tobacco (BATS) and GlaxoSmithKline (GSK). By sheer coincidence, Neil Woodford was quoted in the Times today as saying he thought these two plus National Grid (NG-) were some of the best buying opportunities out there. So I'm also taking a look at National Grid :-)

There is also a bit of portfolio maintenance to be done:

• Take up the TW open offer, and then probably sell out completely once the shares start trading on 1 June. Anything over 33p (about half book value) would be OK - less than that and I'll probably hold onto them.
• Top slice Barclays and reinvest the proceeds in Maxima. Maxima is underweight compared to my other small-caps, and Barclays is over-weight compared to the other banks, so some reallocation makes sense here.
• Crystallise a capital loss on Zirax, to offset some of the capital gain I am making this year (through my job, not my stellar stock-picking). Looks like there's a grey area whether I can repurchase them in my wife's name within 30 days without them being picked up by the bed and breakfasting rules... I'll probably get away with it.
• If I can get a decent price (~110p) sell out of my Lloyds ordinaries, since I have quite enough exposure through the preference shares.

That would leave me roughly:

• 6% in bank ordinaries, 5% in bank prefs
• 7% bonds
• 11% small caps
• 13% Berkshire
• 8% each in GNK, Diageo, Next, 6% in Tesco
• 11% in emerging markets, 9% each in Europe and Asia

In the medium term I'm looking to increase the amount in emerging markets, Europe and Asia. I may add some more bank preference shares.

British American Tobacco

Tobacco looks like a good business - highly cash-generative, stable returns, brand loyalty. BAT doesn't have a lot of debt, and at its current price of 1700p is on a yield of 5%. It has a history of growing earnings at about 10% per year. The P/E ratio is a little steep at 14, but they can pay most of that out and still grow, so those are good-quality earnings.

GlaxoSmithKline

At 1050p this is on a P/E ratio of 12 (10 if you strip out some exceptionals), a dividend yield of 5.3%. I've looked at them before, and noted that their R&D and marketing expenses aren't capitalised, so like BAT these are good-quality earnings.

National Grid

Dividend yield of 5.65%, P/E ratio of about 12 (adjusting for exceptionals). Very high Return on Equity. Very stable revenue.

Conclusion

I like all three of these shares. They're not glitzy, but they earn good money and should be safe. Comparing them to some tremendously good value small caps, I don't think they are necessarily going to outperform. But comparing them to cash or bonds, they should. And that is the more realistic choice I face - I'm already heavily invested in quite risky shares, and I need some balance to my portfolio. Currently that's provided by having plenty of cash, but I'm steadily investing it, and need to buy some safer shares too.

Taylor Wimpey placing and open offer

I don't like it. They've reduced the NAV per share from 150p to 109p through dilution. It's probably good for the company, but I can't be bothered with them any more. I don't see that they have any competitive advantage, and even after all this dilution they're still saddled with £1bn of debt. I sold this morning at 42.5p. I'll look for a better long-term home for my money.

Update 9/5/09:
Just realised (well, my broker informed me...) that the ex-date to qualify for the open offer was yesterday, so I can still take this up if I choose. I'll see what the share price does, but at the moment it's at 37p, so I would gain 12p per share, raising my effective sale price to 54.5p.

LLPF

Today I sold about 70% of my RBS shares at 49.92p (held in a separate sharedealing account to the remainder) and used the proceeds to purchase LLPF at £284.75 per share.

The yield on LLPF is about 21%.

Comparing bonds, prefs and shares

Preference shares
The return on a preference share is actually pretty simply, simpler even than bonds, assuming you hold it forever. Provided the issuer doesn't default, then annual return = yield * par /price.

Bonds
If a bond trades at par, then annual return = yield. Otherwise it needs to be adjusted for its maturity date and price.

Shares
If you ignore the problems of reinvestment, then the return on a share should be straightforward to calculate, provided the RoE of that share remains constant.

For instance, Company A has a RoE of 12%. It distributes all earnings as dividends. Company B has a RoE of 12% and reinvests all earnings. You purchase both at book value (100). Company A pays you 12 per year in perpetuity - a return of 12%. Assuming you can always buy shares in Company A at book value, then you could reinvest each year and compound that 12% growth - Company B simply takes care of that reinvesting for you. The return on both is the same.

As a second example, what if you buy shares in Company A and B at 50% of book value. Company A distributes 24% of your purchase price per year in dividends. You earn a 24% return. Company B reinvests its earnings at 12% RoE, which is 24% return on your investment. If the share price recovers to book, then the owner of A or B is getting a 12% on his newly valuable portfolio. He is still earning 24% compounded on his original investment of 50% of book.

What if you buy shares at twice book value? Now Company A is paying you 6% per year, and Company B is reinvesting at 12% RoE. But if this is the most attractive investment opportunity around, and you own Company A, then you are stuck reinvesting dividends for a 6% return. Company B is reinvesting dividends at a 12% return.

Company B clearly seems a more valuable company. When Company B's RoE exceeds the dividend yield available on Company A, i.e. when companies trade above book value, an investor has a dilemma as to where they can reinvest their dividends. The most attractive option is therefore to invest in a company with high RoE, which has opportunities to productively reinvest earnings, i.e. the Buffett approach.

When companies typically trade at below book value, then it is much less important whether they have opportunities to invest earnings. The biggest driver will be their P/E ratio and P/B value (i.e. the Graham approach). This probably reflects the different investing environments that Buffett and Graham have worked in.

LLPF / LLPG

Of the UK bank preference shares, Lloyds fixed/floating rate preference shares appear the most interesting. These are LLPG, paying 6.3673% and LLPF paying 6.0885%.

At current prices, LLPG is yielding 23.6%, and LLPF 23%. LLPG is callable on or after 2019 at par, LLPG on or after 2015 at par. If LLPG was called at the earliest opportunity that would increase the yield to 37.6%. For LLPF the rate is 48%. If neither are called they revert to 1.3% above LIBOR - assuming LIBOR is ~5%, that means the rate will remain more-or-less unchanged.

The fact that LLPG/LLPF are callable limits the upside - they aren't going to exceed 100% of par value, but when they're trading at ~26% of par, that's not a significant limit.

If interest rates are ~5%, and the banking system recovers to the point of safety, then a yield of 8% would be reasonable. That would suggest 9.75% prefs trading at 122p - a gain of 80% from here. The 6.3% prefs would trade at 79p - a gain of 203%.

If interest rates are 0% (e.g. deflation is rampant) then a yield of 3% might be reasonable. In that case you'd see a 377% increase on the 9.75% prefs, but the 6.3% series should only trade at ~43p, because they will have reset to yield only ~1.3% - only up 65%.

Assuming the economy will recover and banks will become trustworthy again, LLPF and LLPG do seem to offer the best value, both in comparison to other prefs, and also in comparison to the ordinaries. I'll see if I can pick any up next week, and convert some (possibly all) of my bank shares into preference shares.

Bank ordinary vs preference

Ordinaries
The recent run up in bank share prices has left me with something of a dilemma. Back in January it seemed obvious that they were good value, but since then they have rather outperformed:

• Barclays up 220% at 279p
• RBS not far behind: up 214% at 44p
• Lloyds up a mere 61% at 109.6p
• HSBC have had a rights issue, and adjusting for that and their dividend are up a paltry 20% at 482p.

Barclays
I'll updated my Barclays numbers only slightly to take account of the sale of iShares. I make net tangible asset value 333p. Current discount: 16%.

RBS
I'm adjusting RBS's value per share to 47p to take account of their bond swap. Current discount: 6%.

Lloyds
I've realised that my Lloyds valuation in February was thoroughly misleading. In February I rated the shares as having 82p of tangible asset value. But that was after the conversion of preference shares (which at the time was at a price only slightly below the prevailing share price).

We have 13.6bn new ordinary shares after conversion of govt B shares, 10.3bn from conversion of preference shares, and the 16.4bn shares outstanding right now. At the end of the day the tangible net assets are about £35bn (previously assessed at £33bn, but I'm adding in a bit extra for their recent bond conversion) so 87p per share.

Buying one share now and paying 26p to take up your share of the open offer will get you 1.63 shares post-offer. So the value of one share now (in terms of tangible assets) is 116p.

So currently Lloyds are trading at a discount of 6% to tangible net assets.

HSBC
HSBC hasn't changed since my calculation in February: value 353p per share. Current premium: 37%.

Ordinaries conclusion
Assuming a reasonable, conservative valuation is 1.2x book value, Barclays could still rise 44% from here, RBS and Lloyds a further 28%. HSBC is already trading at a premium to this valuation measure. Assuming a RoE of ~12% (pretty conservative), at a premium to book of 1.2, the banks would be on an earnings yield of 10%.

Preference shares
Lloyds have preference shares with a gross yield of 9.75%, currently trading at 68p. A return to par would see these rise 47%.

RBS (via NatWest) have 9% preference shares trading at 66p, so a similar situation.

These would appear to be marginally better value than the ordinary shares. They share the downside of complete wipeout, have an additional risk of banks opting not to pay dividends (they are non-cumulative), but do not have the same dilution risk.

IEEM, IAPD, IDVY

Increased my holdings of all 3 of these a few days ago, at the following prices:
IAPD @ 1112p now 8.6% of my share portfolio
IDVY @ 1233p now 8.7% of my share portfolio
IEEM @ 1678p now 10% of my share portfolio

The breakdown of my entire portfolio including US dollars is:
USD: 39.7
Large UK Shares: 23.3
Large USA Shares: 8.1
Small UK Shares: 7.0
Large Emerging Shares: 6.1
Large Europe Shares: 5.3
Large Asia Shares: 5.2
UK Bonds: 4.3
Small Emerging Shares: 1.1