James Hannam, who makes his Eureka Report debut today, highlights questionable manoeuvres at ThinkSmart. James is a former equity research analyst with Goldman Sachs and is a one-time professional cyclist. Welcome aboard!
-James Kirby, managing editor
Summary: TSM is proposing to buy back 50% of its issued capital at a price between $0.31 and $0.42 per share. This buy back potentially risks an effective transfer of control to the executive chairman as well as a reduction of liquidity. Furthermore, we do not believe that the valuation range adequately reflects underlying value of the residual business or compensates investors for these risks. Following the outcome of the EGM we will provide a further update early in the New Year.
Key take-out: We suggest that shareholders vote against the proposed buy back in its current structure.
Key beneficiaries: General investors. Category: Small caps.
Point of sale consumer finance business, ThinkSmart, has proposed to buy back up to 50% of its issued capital at between $0.31-$0.42 per share. Following the sale of the group’s domestic operations last year the company is left with cash holdings of $0.245 per share and UK operations which can generate ~$0.02 in earnings per share. Clearly capital management is appropriate considering the company’s cash balance but we are not convinced that the proposed buy back, in its current structure, is the best outcome for minority shareholders. Eureka Report currently has a Buy recommendation on TSM, which is under review pending the outcome of the group’s extraordinary general meeting.
What do investors need to do?
Firstly, investors need to consider whether to vote for or against the buy back.
On Monday, December 22, an extraordinary general meeting will be held in order for shareholders to vote on the proposed off-market buy back. For the buy back to proceed, more than 50% of the votes need to be cast in favour. Shareholders can lodge their proxy form electronically or via post or they can vote in person at the meeting.
Many off-market buy backs have been lucrative in recent years. How does this compare?
Simply put, not particularly well.
Let us first touch on why many off-market buy backs have been worthwhile in the past. There are numerous examples in recent years where participating in off-market buy backs has been a lucrative trading strategy. This is particularly the case for private investors benefiting from low tax rates (i.e. those investing through an SMSF).
The key reason for this is that when stock is acquired via an off-market buy back, the company can, in most cases, treat the proceeds as a combination of a capital return and a fully franked dividend.
For example, in 2011 JB Hi-Fi bought back 9.9% of its issued capital via an off-market buy back at $16.00 per share. This $16.00 comprised a capital component of $0.58 and a fully franked dividend of $15.42, with an associated franking credit of $6.61. This resulted in a grossed up, pre-tax sale price of $22.61, which compared favourably to the deemed market value at the time of $18.31.
Unfortunately, TSM is not in a position to provide such a favourable structure should the proposed off-market buy back proceed.
As at June 30, 2014, TSM had a franking balance of $2.89 million. In addition, the company has noted that if the full 64.5 million shares were bought back at a price of $0.36, then ~$1 million of franking credits are expected to be distributed. This translates to a capital component of $0.32 and a fully franked dividend of $0.04 per share and highlights the limited franking credits available.
Is the valuation range appropriate?
A key question investors should ask in considering whether to vote for or against the proposed buy back is whether the valuation range of A$0.31-A$0.42 is appropriate.
Fundamental value: Some high-level thoughts
Adjusting for the company’s $36 million net cash holdings, the implied PE, based on management expectations, at the lower end of the buy back range is 3-4 times FY15 earnings, while the top end of the range is 8-9 times FY15 earnings.
While this is below the ~10 times FY15 PE (according to Bloomberg consensus) that TSM’s competitor Flexigroup trades on, the top end of the range is closer to a level that could be deemed appropriate considering the liquidity and execution risks present in the business. However, even the top end of the range certainly doesn’t include a premium for potentially transferring effective control of the business. More on this below.
Independent Expert’s report: We have some concerns
TSM commissioned an Independent Expert’s (IE) report in relation to the proposed buy back. There are a number of reasons why commissioning such a report is appropriate in this case (which we don’t need to dwell on), however we do have some concerns regarding the valuation range arrived at. Specifically, we note that the IE arrived at a “fair value” for TSM of $0.33-$0.39 per share. There are some important points that we think need to be highlighted regarding this valuation.
1. The report uses a “market value” approach. In other words, this valuation is simply the trading range of TSM between December 12, 2013 and November 10, 2014.
In a period when the firm’s major operations are sold and there is significant uncertainty around capital management as well as board/management/strategy continuity, we would contend that the trading range is not necessarily representative of the underlying intrinsic value of the residual business.
2. The report argues that “market prices of companies listed on a stock exchange usually reflect the prices paid for small parcels of shares representing minority interests (i.e. a non-controlling interest) and as such do not include a control premium relevant to a significant parcel of shares”.
To us this seems like an intriguing argument. Just as a minority shareholder will benefit from a share price premium in the event of a takeover offer, in our view, some sort of premium is warranted in the event that an individual or group will potentially acquire an effective controlling interest. This is a distinctly possible outcome in this buy back.
Potentially forgoing effective control without a premium
Ned Montarello founded ThinkSmart in 1996, is the executive chairman and currently controls 21.1% of TSM. He has indicated that he will not tender his shares into the off-market buy back which, if the buy back proceeds, will result in an effective increase in his proportional ownership of the company.
If both the on-market (TSM is currently undertaking a 10% on-market buy back) and the proposed off-market buy backs are completed in full, Ned Montarello’s voting power could increase to 45.9%.
This is an important point as under an ordinary resolution (which requires 50% shareholder approval), if less than 91.8% of votes are tendered, Mr Montarello could carry a motion even if all other shareholders voted against the proposal. Clearly, Mr Montarello would also have significant influence on the outcome of any special resolutions (which require 75% approval).
We suggest that shareholders make the effort to vote, and vote against the proposal
A clear potential outcome, if this buy back proceeds, is that minority shareholders will subsequently have access to significantly less liquidity and they will potentially be transferring effective control of the company to one individual. We are not convinced that the buy back range of $0.31-$0.42 adequately compensates shareholders for these risks and suggest votes be cast against the resolution on Monday.