I try to look at business reporting the same way W.E.Deming suggests we look at quality control results: by asking whether the change in results versus last period is caused by a “common cause” or a “special cause”. A common cause would be something like the year-to-year change in business conditions or a large increase or decrease in cash caused by a long-foreseen divestment of an unprofitable business segment. These are things which cause variation but don’t change the overall quality or financial safety of the business. Such things shouldn’t be a reason to sell a holding although they may indicate a good time to buy a particular company. The main value I see in common cause variations is that they provide more data to help understand the range of valuation of the business.
For me, a special cause is something that changes the quality or financial safety of the business, particularly if it invalidates an investment thesis. Examples I can think of are:
- Entry to new markets or exit of existing operations.
- Loss of financial safety. For example, interest coverage falling to an unacceptable level.
- Irrational management decisions such as continuing to pay dividends when the balance sheet is in poor shape.
- A change in the structure of a market. For example, increased or decreased government regulation or disruption by new technology.
By way of example, here are my thoughts on the ERM Power (ASX:EPW) 2018 results:
- By removing mark-to-market losses caused by accounting for the derivative position and a one-off loss caused by a change in tax laws I arrive at a normalised EBIT of around AUD 79MM and distributable earnings of around 77 MM (see my earlier post on EPV calculation for how I do this type of calculation). Both of these figures are within the range I expect based on previous history. These variations are of the common cause type. Nothing to see here.
- An increase in “underlying NPAT” (whatever that is) from -AUD 16MM to +AUD 30MM. This was foreseeable based on the strategy of making a short-term payment in order to allow a long-term gain through surrender of LGC’s which EPW mentioned in previous years’ reporting. Whilst this is probably responsible for the 10% jump in share price on the day of reporting, I see it as a common cause variation. Nothing to see here.
- A substantial increase in net debt caused by changes in working capital, specifically margin requirements. Whilst this is a cause for concern the business has enough cash to pay off 2/3 of its long term debt immediately and could pay off the balance with a year’s worth of distributable earnings. I see this as common cause variation but it would become special cause if the situation continued or grew worse.
- Sale of the US business segment. This one I see as likely to be a special cause variation. Although the US business had grown by 6x since purchase in 2015 a decision has been made to divest. A possible reason for this could be that the difficulty in taking enough market share to reach scale was seen as higher than previously. As the sale is already underway, perhaps EPW received an offer too good to refuse. Either way, this reduces the likelihood of growth in the business but also shows management restraint in not continuing to pursue a market which is not likely to be profitable.
Because the current share price is well below what I would be prepared to pay for EPW without taking growth into account the special cause mentioned above is not a reason to sell. If the company were priced such that future growth was required to justify the valuation then now would be the time to sell.
The other elephant in the room with EPW is government intervention in the power market. This has been in the news recently and is a possibility in the future. However, because the E&I segment that EPW operates in was not criticised in the recent inquiry I think the chance of intervention in the C&I market is low. It’s something to keep a close eye on though.
If you have questions or comments please write to Warwick at firstname.lastname@example.org. I answer every email that I receive.
Disclosure: I currently hold EPW. This is not a recommendation to buy or sell any securities, nor is it financial advice. All information presented is believed to be reliable and is for information purposes only. Do heaps of your own research before purchasing any security, especially any that I have discussed.