Description

Andrews Sykes is a high quality business, consistently generating decent returns on capital (19.3% 10 year average ROA), significantly owned by a very capable capital allocator Chairman and his family.  He is very old.  It is very illiquid.  It is not cheap, but what is?

Introduction

Don’t read this if you want to invest institutional money.  Or even PA.  For those VIC members eager to invest 2014’s capital allocation to the medical fund for a pet dog, this stock might just about meet your liquidity requirements, despite being less liquid than its micro-cap status would suggest due to a free float of just 9.9% of market cap.  However, this is a boring business that struggles to grow sales or profits even in line with UK inflation, yet presents a stock price chart that looks kinda growthy.  Buying micro-caps at all time highs, without a liquidity discount, is hardly orthodox value investing.  Go ahead, rate me low, I deserve it.  The singular insight I present here is not even mine, and I quote it second hand:

“Look at the cannibals”

Charlie Munger, according to Pabrai, has said that:

“if an investor just did three things, the end results would be vastly better than the rest. And he said one is carefully look at what the other great investors have done. So, in fact, Charlie was endorsing copying off the 13Fs, right? So he said look at what other great minds are doing.

And the second thing he said is, look at the cannibals. And what he meant by "look at the cannibals" is, look carefully at the businesses that are buying back huge amounts of their stock. Because they're eating themselves away, so he called them the cannibals.

And the third is, he said, carefully study spinoffs. Of course, you know Joel Greenblatt has a whole book on spinoffs: You Can Be a Stock Market Genius Too. And so I found it interesting that Charlie basically said that investment operation that focused on these three attributes would do exceedingly well.”

http://www.fool.com/investing/general/2013/01/10/mohnish-pabrai-what-ive-learned-from-warren-and-ch.aspx

Andrews Sykes is a cannibal in the sense that through aggressive buybacks at very cheap valuations, the total share count has been more than halved in the past twenty years since Jacques Gaston Murray (“JG Murray”) become responsible for capital allocation on his appointment as Chairman in June 1994 at the tender age of 74.  All this repurchasing has increased his family’s stake in the company from 59.5% to 90.1% during that period.  For those concerned that this cannibal cannot possibly have any appetite left, he and his family also control the larger and separate London-quoted company London Security PLC, also a good business, but more expensive than Andrews Sykes, and with even less free float due to the Murray family’s extraordinary 98.83% shareholding. 

Despite Munger’s advice, studying cannibals does not seem anywhere near as common as either copycat investing or spin-offs, probably simply because there are few examples as aggressive as this:

Capital Allocation

Over the past two decades since gaining control, JG Murray has spent 30% of post-tax cash flow from operations (not free cash flow) on capital expenditures (net).  Adequate maintenance capital expenditure for a capital equipment hiring business is sine qua non; more importantly, for a business that generates such high returns on capital, this has been a great use of capital.

Of the rest (CFO less capex), 22% has been spent on net acquisitions (admittedly with mixed results); 72% has been returned to shareholders; and the small remainder has been reinvested in working capital (again with high ROC).  Much of the return of cash to shareholders has been by the extraordinary amount of share buybacks.  From a starting market capitalization of less than £12 million, over the next twenty years the company spent £65 million buying back stock, at an average price of £1.26 per share (not adjusting for dividends).  Buybacks have been value-orientated: increasing as the valuation improved, decreasing or stopping completely when the stock rallied.

Business quality

Most of the company’s revenues are generated by hiring environmental control equipment (i.e. portable heating, air conditioning, drying and pumping equipment).  Sales and installations of the same kind of equipment makes up the balance.  Two thirds of sales are in the UK, the rest is split between continental Europe and the Middle East. 

This is a high quality business, despite few opportunities for growth.  The sustainable competitive advantages of local economies of scale should be obvious from the following business description:

“As the UK's largest specialist hire company, we provide the best pumping, heating and cooling solution for virtually every need, location and application 24 hours a day, 365 days of the year. Our aim is to help our customers to address the real-life challenges they face-whether planned or emergency-in the fastest, most expert, professional and cost effective ways. We offer the safest, most reliable equipment sourced from the world's top manufacturers.

Andrews Sykes Hire features the two premier brands of the UK hire industry: Sykes Pumps and Andrews family of climate control brand, which are: Andrews Air Conditioning, Andrews Heat for Hire,Andrews Dehumidification, Andrews Chillers, Andrews Boilers and Andrews Ventilation.

The Andrews brand has more than 40 years’ experience dealing with hire, sale, installation and maintenance of all types of comfort cooling, air conditioning, heating, temperature control, ventilation and dehumidification systems, making us the UK's biggest and most reliable specialist hire company.

Sykes Pumps has more than 150 years’ experience in delivering advanced pumping and ground water solutions. No other company has more expertise and heritage in pumping, de-watering and specialist fluid moving than Sykes pumps. Starting on the banks of the Thames way back in 1857, our long history has seen us supporting key projects across the UK, both planned and emergency. A lot has changed over the years but our commitment to delivering the finest equipment and exceptional service hasn't.

Today, Andrews Sykes has depots strategically placed to offer a local service across the world. We have over 300 dedicated employees trained and ready to help you. The dedication of our people and the values of our company give our customers the trust and faith to use our service time and time again.”

http://www.andrews-sykes.com/info/about-us/  

For any local market already well-served by a depot that keeps a varied range of well-maintained, up-to-date rental equipment, there is little incentive for new entrants to commit the substantial capital required to enter as a new competitor.  A typical depot visit presents enough equipment lying idle to convince customers that they will be able to hire what they need when they need it, but also to caution any would-be competitors.  When a commercial client hires equipment, for example due to flooded premises, the threat of substitute products is low.  (Air-conditioning does have a more credible threat of substitution in the form of permanent air conditioning rather than temporary hire in hot summers).  Price is typically low on the list of deciding factors for customers (immediate availability of well maintained equipment delivered quickly from a local depot is far more important), at least in the short term and in the absence of the abusive, monopolistic pricing that would encourage rivals.  Meanwhile the equipment itself is commoditized, so the company can purchase at their leisure from various suppliers, while being the first place to call for most customers during peak demand.  Add up all these competitive dynamics, and a well-managed business should be able to earn above average returns on capital.

Returns on Capital

Sure enough, returns on total assets have averaged 19.3% over the past decade, impressive for a business which is asset-heavy, without obvious IP value creation, and where median total compensation is well below its £31,000 per capita mean.

Furthermore, there is evidence that sustainable competitive advantages will be applied to sustaining high returns on capital into the future, rather than being tempted to pursue any other foolish secondary objective (such as growing sales to advance executive compensation).  The stated Key Performance Indicators for this tiny company would make many megacaps blush, and I think predicts a high quality business into the future if management remains focused on them. 

High on the list is: “Operating cash flow as a percentage of operating assets employed” which is defined as “Cash generated from operations before defined benefit pension scheme contributions,” divided by, “net assets employed excluding pension assets and liabilities, loans, deferred and corporation tax balances, bank deposit accounts and cash”. 

For a business where the appropriate level of spending on capital investment and maintenance is a constant and significant management decision, which could easily be made using a completely erroneous framework, clearly aiming for the right goal is of paramount importance, which is why I pay so much attention to stated KPIs in this instance. 

During the past eight years in which management has stated this return on capital objective, their results have been far from micro:

Management & Board

Jacques Gaston Murray continues as Chairman to this day, and will celebrate his 94^th birthday next month.  I suspect that he has generated more shareholder value after the age of 74, and simultaneously had more fun in his business exploits, than most executives achieve in a lifetime career before retirement age.  Since becoming Chairman, he has elected to receive no direct compensation for his ongoing stewardship of the business, which I suppose is just as well given the potential for abuse, and hopefully serves as a good example in the future.

JG Murray’s two sons, Jean-Jacques Murray (47) and Jean-Pierre Murray (44) both serve as non-executive directors, and earn commensurate compensation.

JG Murray’s personal life has been heroic, inspiring, at times tragic, and colorful.  As far as business interests go, there seems to be a cohesive pattern of intelligent capital allocation and understanding of maximizing one’s competitive advantages.  The family (together with some current and former non-executive directors) share business interests in both companies mentioned here (ASY.L and LSC.L) and also hold significant investments in Miami hotels:

http://www.miamihotelgrandbeach.com/miami-beach-hotel-development-team/

Paul Wood, a sprightly 51 years old, returned to the business 8 years ago as professional (non-family) CEO, having first joined the business at age 16.

Key management compensation over the past years has peaked at 3.5% of sales, during which time operating margins have ranged 20.7-27.9%.

Valuation

I saved the worst for last, hoping that no-one makes it this far.

At £3.35 per share (ask), on a trailing one year basis, EV/EBIT is 9.0x, or 9.3x for the prior ten years.  Not cheap, but with 10% of market cap in net cash, at least the balance sheet is quite safe.

Additional risks

• Corporate governance risks typical for micro-cap investing.
• Debt: sooner or later some overly-educated individual normally points out, often for a fee, that a no-growth, predictable business like this can handle a lot more financial leverage.  To quote Munger again, (but not verbatim), 'that is a bad idea for most people; however, if you are old and rich like us, it is a terrible idea.' 
• Past performance does not necessarily predict future success.  It would be understandable, but wrong, for both shareholders and future management to think that historical success can be extrapolated without serious work.  This is an unglamorous cash cow, but sometimes those are the easiest for incompetent/lazy/overpaid managers to mess up. 
• Succession: the controlling parties of the company (various trusts and companies which have some relation to the Murray family) might act differently in the future, especially after the current Chairman eventually leaves the business, to the reasonable way in which they have acted in the past.  Ongoing sensible capital allocation, appropriate corporate governance, restrained compensation and fair treatment of minority shareholders will be the responsibility of the next generation, and are clearly not guaranteed.
• Various risks of a defined benefit pension are even more relevant for a microcap, undiversified business like this.  However, the plan is closed to future accrual and currently is in an accounting surplus.
• Climate – short term vagaries can make earnings lumpy (shareholders dislike mild summers and dry winters), and longer term trends can increase the threat of substitutes (permanently-installed air conditioners seem to becoming more common in parts of the UK market).
• N.B. miniscule liquidity.  I and affiliates own shares and can sell at any time without updating this board.

Catalyst