PORTFOLIO POINT: Higher debt, a declining return on equity, and imminent changes to legislation look set to reduce Cabcharge’s earnings.
The downgrading of earnings by listed Aussie companies has been flowing thick and fast, and even top companies are not immune to the business cycle. This week it was Seymour Whyte’s turn, with a substantial reduction in expected profits triggering a 40% fall in the share price.
The Montgomery [Private] Fund has not owned Seymour Whyte for some time because I believed that the potential for a slowdown in Queensland government spending could impact the project pipelines and then margins of civil engineering companies. More importantly, one of my key criteria was no longer being met; bright prospects for intrinsic value growth did not exist. Expected growth in intrinsic value was simply not at a satisfactory rate. So SWL was sold a while ago.
Now take a look at Cabcharge (Fig 1.). Like Seymour, CAB is an A1 – which means it isn’t going broke anytime soon – and it’s now trading again below its estimate of intrinsic value. If you only looked at those two elements you’d be tempted to dive in.
Fig 1. Cabcharge Australia share price
But investors need to dig deeper. Taking a look at the following cash flow chart from Skaffold (Fig. 2) you can see that reported profits (green columns) have been in decline for a few years. You can also see that cash flow from operations (the blue line) has been less than reported profits in recent years.
Fig. 2. Cabcharge Australia cash flow
Perhaps most importantly, the green funding gap line has been negative. This means that the company has not had sufficient self-generated cash to meet the acquisitions and/or investments and dividends it has made since 2005.
Since 2002 the company has generated $394 million in cash flow from operations but it has invested $285 million and paid dividends of $258 million, leaving a Funding gap of $150 million.
In order to plug the 'funding gap’, the company must either raise capital from owners (dilutive) or borrow more. As Fig. 3 reveals, this has occurred.
Fig. 3. Cabcharge Australia debt
Total debt (the red columns in Fig. 3) has risen by $134 million from $12.4 million in 2002 to $147 million in 2011. I tend to dislike companies with increasing gearing as this means more risk – but not the risk of collapse in the immediate future.
Equity capital raised from owners has also increased, in this case by $67 million since 2002 to $138 million in 2011. Despite the increase in debt, and perhaps because of the increase in equity (and of course the inability to expand the network beyond its mature state or the inability to further raise prices due to emerging competition), earnings have not risen sufficiently since 2002 to sustain a very high rate of return on equity. Back in 2007 return on equity neared 30%. Today it sits at less than 19%.
Interestingly, after many years with no activity, Reg Kermode, the man behind Cabcharge, reported to the ASX that he had sold 89,000 of his 189,000 shares in January.
But more recently, the RBA issued its “A Variation to the Surcharging Standards: Final Reforms and Regulation Impact Statement” report. At the 18 May meeting, the Reserve Bank’s Payments System Board decided that it will vary the surcharging standards to limit surcharges to the reasonable cost of card acceptance. The standards are designed to ensure that merchants can fully recover their costs.
Importantly, the “Reasonable Costs of Card Acceptance” includes, but is not limited to, the merchant service fee, other costs payable to acquirers – fees for rental and maintenance of payment card terminals, other fixed fees for providing payment acquiring equipment and services, costs payable to other payment service providers – gateway fees, fees for provision of equipment and/or services required to accept card payments, and merchant’s own costs such as the cost of purchasing and maintaining card acceptance infrastructure including line rental and communications charges.
While Cabcharge must now demonstrate that its 10% credit card surcharge reflects its cost of card acceptance, the RBA’s report is itself the result of a report on the Victorian taxi industry inquiry. That report recommended that all electronic payments surcharges including for Cabcharge be reduced from 10% to 5%.
On the positive side for CAB, the changes will also impact Cabcharge’s competitors and the company may be able to reduce costs elsewhere to offset the negative impact of the reduced surcharges. But the company’s own announcement suggests it won’t take the changes lying down.
CAB has declared that the 11% fee is a 'service fee’ rather than a 'surcharge’. One expects the RBA to look at CAB’s argument. More importantly however, if the RBA wins the argument, CAB will have to negotiate with credit card companies the appropriate level of surcharge and Mastercard has welcomed the RBA’s draft proposal. Mastercard reckons the average merchant service fee for its cards was only 0.86%, suggesting even 5% is highly unlikely to be accepted.
Currently a $50 fare produces an additional $5.50 fee. Whatever the combination of charges CAB dreams up to navigate the new regime – a lower-cost recovery percentage plus a fixed fee of, say, $2, like an ATM – the result must be less marginal revenue.
Obviously not everyone agrees and Lazard Asset Management, for example, has recently increased its substantial interest in the company and lifted its holding to more than 8%.
The introduction of revised standards is scheduled for the start of calendar year 2013, and no matter how cheap CAB may look today, I expect downward earnings revisions to creep in if the RBA looks like winning. This would lower future valuations and thereby erode any apparent current margin of safety.
And finally, two points: Even if the margin of safety remains, an RBA win would reduce the rate of growth on intrinsic value for CAB, and for me that means it wouldn’t meet all of my investment criteria. Intrinsic value would not be rising at a fast enough clip. Alternatively, if we assume that CAB wins and the best outcome is that the status quo is maintained; how will that do anything to stem the tide of declining profits and weak cash flows the company already sustains with its current surcharges intact?
Only if you believe competitors will be worse off and fall by the wayside – sending more drivers back to using Cabcharge – would you have any confidence that the economics of the business are going to meaningfully change. And even then, one wonders whether a new and well-funded competitor would also emerge to fill to void.
While CAB is not going broke any time soon, there are industry forces at work that place the company’s prospects under a less certain lens. And any resolution in the company’s favour may not be sufficient to change the trend that already appears to be in place.