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Is CIL a buy, a hold, or a sell at current levels?

The short answer is a yes, the long answer aims to justify why.

Introducing Consolidated Infrastructure Group (CIG) (ticker symbol – CIL)

CIL is a JSE-listed holding company that invests in, and operates, a range of businesses that focus on developing infrastructure on the African Continent. These guys are currently operationally active in three main segments of the broader infrastructure space, building materials, power, and rail, and significantly invested in a 4th (oil and gas).

CIL conducts business in what they refer to as the “Big 5 +1” geographies, being South Africa, Angola, Ghana, Nigeria, Saudi Arabia, and East Africa.

Africa is not a place for the faint investor heart. We all know that. But, the potential economic rewards to those who get it right are very material indeed. Those in the business of making macro forecasts tell us that the potential market for power infrastructure on the continent is in excess of $40 billion; $90 billion if you include other infrastructure needs as well.

Risk is part and parcel of the very sizable potential rewards to be had on the continent, but it seems that CIL is prudently going about managing it thus far. One must keep in mind that the company, until now, has been largely projects-based. In other words, CIL makes money from construction contracts (80% + of Revenue in 2016). As these projects, mostly in CIL’s power segment, may run over multiple years, they require significant working capital management investment. Solvency and liquidity risk is very real when the cash you receive does not match the accounting revenues and profits you bring to book. To this end, CIL have a conservative gearing policy (16% net gearing at present) and close to R1 Billion in short term facilities available to cover short-term liquidity short falls.

CIL’s operational risk is managed by having a local presence on the ground in every country that they operate in. Management has indicated that it is strategic priority to partner with, or invest in, local talent and knowhow. This does not eliminate operational risk, but employing or partnering with people who probably have a much better idea of the idiosyncratic risks faced in these various localities is on the face of it a very good idea, even if it results in increased labour costs (which it does).

It’s a big positive that CIL is geographically diversified and that they are involved in a variety of different infrastructure activities. This geographical and sector diversification should provide at least some protection against volatile economics and unstable politics.

It is in the nature of political self-preservation that politicians would probably rather spend decreasing government finances (due to rising or falling oil prices) on securing political incumbency in the here and now, rather than on tomorrow’s much needed infrastructure. It is thus comforting to know that CIL is naturally oil-hedged, as Angola, Nigeria, and Saudi Arabia are oil exporters, while South Africa, Ghana, and East Africa are oil importers. As oil is such a big part of the revenue (oil exporters) or expense side (oil importers) of African economies income statements, this natural geographical hedge is particularly important to a business that relies on chunky project-based revenue for its economic well-being.

CIL Operations and Finances

The Group

As I write this, CIL is trading at R20.60 per share; it has a market capitalization of R4.163 Billion, (202.8 million ordinary shares outstanding X R20.60) and is currently on a historical Price Earnings (PE) multiple of 8.24 times. CIL’s 5-year average PE is 13.38 times.

For the financial year ended 31 August 2016 CIL generated R 4.531 Billion in revenue and profit after tax (PAT) of R392.8 million. Revenue was up 25.74% on 2015’s result while PAT measured 18.5% higher. On a per share basis, diluted headline earnings per share (HEPS) clocked in at 250.0 cents per share in 2016 and 222.51 cents in 2015, an increase of 12.35%. Even a dead cat bounces at least once (sorry cat lovers – put “dog” in there if you like) and therefore it is definitely worth your while to consider more than one years’ worth of historical results when assessing the financial performance of a firm.

When we do that we see that the 5- year historical performance of CIL with regards to revenue growth has been very impressive indeed. From 2012 to 2013, CIL grew revenues by 31.15%. From 2013 to 2014, CIL grew revenues 29.37%. From 2014 to 2015 CIL’s top line performance came in at 36.74%, while in the year ended August 31st 2016 they managed to grow revenues 25.74%. That is a compounded annual growth rate (CAGR) of 23.88%.

If we do the same for profit after tax (PAT) and headline earnings per share (HEPS) we see that PAT grew at a CAGR of 23.46% and HEPS 17.26% for the 5 years ended 31 August 2016. This is the stuff value creation is made of. Unfortunately, it is not the only necessary ingredient to that end.

If there are any possible criticisms here it may be that they are growing revenues too fast and probably not as efficiently as what one would like them to. Remember that the fundamental value of a business is a function of 3 variables: (1) the growth in quality profits (g), (2) the opportunity cost of capital (k or WACC), and (3) the return on capital (ROE or ROIC or ROA etc.). Each of these variables depends on more variables, but we won’t go into that here, not unless you suffer from insomnia. The relevance here is that it is easy to think that CIL is positively Olympian in generating economic value when only considering the growth (g) part of the valuation matrix, but are they as Herculean in performance with regards to the other necessary fundamental metrics, the cost of, and return on, capital?

The opportunity cost of capital is essentially the expected rate of return that you and I could earn on the next best use of our investment funds. For example, we may have the option of investing in CIL shares or some other asset ABC with the same estimated risk-versus-return profile. The return that we are giving up (ABC’s return) by choosing to invest in CIL instead is the cost of capital (k) if we are talking about equity exclusively or the WACC if we are talking about a combination of debt and equity.

Bloomberg estimates that CIL’s weighted average cost of capital (WACC) has averaged 9.62% during the last 5 years (9.93% as at 31 August 2016) and its average cost of equity (k) has been 9.72% (9.53% as at 31 August 2016). Bloomberg clearly hasn’t been to Africa yet; I wouldn’t even risk R1 for less than a 15% return on any continent-based equity investment. Furthermore, how could it possibly be that CIL’s cost of equity is only a few basis points north of the 10-year SA government bond yield of 9%? Surely investors would require a bigger return bang for their invested buck, especially on equity.

Somewhere somebody is pulling rabbits out of hats, because CIL management estimates the WACC to be 13.2% (incidentally, they also estimate the ROCE at 15.2% – way higher than my own estimates). In no universe that I know of is the same thing (WACC) measured over the same period (2016) 9.93% AND 13.2%. One or both of these numbers are wrong, OR each group works out the WACC in a different way and/or for a different time period. Be that as it may, I think it is better to go with the more conservative CIL management estimate of 13.2% for the WACC or some value reasonably close to it.

The return on capital, however it is measured, is fundamentally a measure of how well (efficient) the stewards of a companies operational assets are in sweating profits from those assets. If we measure the “capital” in “return on capital” as capital employed, then the return on capital (ROCE) measures how efficiently management is able to generate operating profits (EBIT) on that capital (equity + debt). To generate value, the return on capital employed (ROCE) must be higher than the opportunity cost of that capital, otherwise it would have been better for us to invest our equity and/or debt capital somewhere else (asset ABC for example) where the ROCE is higher than its cost.

In 2012, CIL reported a ROCE of 13.08%. In 2013, the ROCE measured 13.06%. In 2014, the ROCE measured 10.46%. In 2015 and 2016, the ROCE’s were 11.07% and 10.07% respectively. The 5 – year average was 11.54%, but the trend has been edging lower and seems to be settling close to a level of 10%.

IF the WACC is as indicated by Bloomberg, then CIL is generating a ROCE slightly better than its cost (5 year average ROCE = 11.54% versus 5 year average WACC = 9.62%). Using spot rates for the ROCE (2016) and the WACC (Bloomberg 2016) we see that the ROCE was 10.07% versus 9.93% for the WACC – hardly world beating.

However, I am reasonably optimistic that the new Conlog acquisition (October 2016) for what will probably turn out to be R850 million will raise the groups overall returns on capital. Conlog generated R106 million PAT for the financial year-end 31 December 2015 which implies that the acquisition happened on a historical PE of just over 8 (earnings yield of 12.47%) and probably less (greater yield) considering that the R850 million price tag applies only in the event that Conlog achieves certain profit warranties (presumably more than R106 million PAT).

CIL’s remuneration policy indicates that the boys (and girls) only get paid extra (in share options) when the Ebitda of the group rises by at least 16%/annum over a 4 year period. I suspect that this implies that Conlog’s profit warranties are related to such a rate (16%/annum) and therefore one could perhaps assume that Conlog will have to generate around R136 million PAT (and an Ebit higher or equal by implication) for the year ended 31 August 2017 (R106 million X 1.16 X 1.106) and so forth. If this is true, then the R850 million-acquisition price implies a PE of around 7 times (14.3% in yield terms), which is getting close to great value.

Lets assume that Conlog will add R136 million Ebit to CIL for the year ended 31 August 2017. We know that CIL raised R750 million by means of 38 million shares at R19.30 per share to fund the initial payment. Another R100 million in debt financing or cash will probably be forthcoming in due course. Lets assume that CIL can manage another year of 12.3% growth in Ebit (the 2015 to 2016 performance). This means that (excl. Conlog) the Ebit for the group will rise to R452 million from R402.9 million as of 31 August 2016.

If we want to estimate CIL’s 2017 ROCE, we need to add the following: (1) the R440 million PAT CIL will earn (assuming g of 12.3% and no dividend payouts) (2) The R136 million Ebit Conlog will presumably earn. (3) The extra equity and debt raised in the Conlog acquisition (R750 million + R100 million debt)

Doing all of the above and assuming CIL ends up with a D/E ratio less than 30% we see that the estimated ROCE for CIL in 2017 is 10.9%.

A simple back of the envelope valuation of CIL can now be done:

Value of entire business (debt + equity) = Ebit (2017)(1-(g/ROCE)(WACC – g)

= R588 million (1-(0.06/0.109)(0.0993-0.06) = R6.726 Billion – Debt of R1.214 Billion = R5.511 Billion or R27.17 per share

Where Ebit is R452 million + Conlog’s R136 million = R588 million

Growth = g = 6% (SA inflation rate)

WACC = Bloomberg = 9.93%

ROCE = 10.9% (2017 estimate)

IF we instead use CIL managements WACC of 13.2% then:

Value of entire business = R3.671 Billion – R1.214 Billion = R12.11 per share (ouch!)

I can be wrong off course on any and/or all of the inputs to the valuation model. IF the WACC is really 13.2%, then it does not matter how fast this business grows, it is in fact destroying value for those who require 13.2% on their weighted average capital invested if it merely makes 10.9% on that capital.

However, IF CIL’s WACC is closer to the Bloomberg value, lets say 11%, then:

Equity Value = R5.286 Billion – R1.214 Billion = R4.073 Billion or R20.08 per share. (Not far off current share price of R20.60)

Perhaps I have underestimated the future sustainable ROCE of CIL, especially given the new capital light, highly cash generative Conlog. IF Conlog manages to raise CIL’s ROCE back to its 5 – year average rate of 11.54%, then:

Equity Value = R5.645 Billion – R1.214 Billion = R21.85 per share

Where WACC = 11%

Finally, there is also the very real possibility that I don’t know the real level of capital needed to generate operating profits in this business. A clue that this may be the case is that management – the same guys that tell us that the WACC is 13.2% – also claims that the ROCE was in fact 15.2% in 2016.   My growth rate assumption of 6% could also be inadequate given the estimated size of the market for the firm’s products (Conlog is forecast to have 15% REAL growth in demand per year going forward for at least the next 5 years). Assuming a ROCE of 15.2%, a WACC of 13.2% and g of 8%, we see that:

Equity Value = R5.356 Billion – R1.214 Billion = R 4.142 Billion or R20.43 per share.

IF g = 9%. The Equity Value = R5.710 Billion – R1.214 Billion = R4.497 Billion or R22.26 per share

CIL: A Speculative Buy

We have inserted a few numbers into a simple equation to get one number – the supposed value of CIL shares. But, which version of the equation, if any, are we going to trust as a basis for an investment decision?

It is tempting to throw out the R12.11 estimated value per share as clearly wrong (but haven’t we perhaps cheated by taking a sneak peak at what the current price (R20.60) in the market is, and then declaring that as the reason for our R12.11 estimates falsity? That’s begging the question if you ask me. Aren’t we supposed to show that the conclusion that the market reached with respect to the relevant share (its price) is justified? Not use that very same conclusion (market price) to show that our argument for its justification is unjustified! (Note: To my mind the R12.11 is too conservative because it uses an ROCE that is probably too low considering the change in the portfolio mix (Conlog) of CIL. Furthermore, the WACC of 13.2% may in fact be too high if CIL management finances at least part of the balance sheet on a US Dollar or Euro basis as they have indicated (the borrowing rates will presumably be lower than borrowing in Rand and will be matched by revenues of 50%-plus in hard currency).

Some of our other arguments, for a lower WACC and/or higher ROCE and/or higher g show that the justified price of CIL shares is around the R22 level (There is probably about R1 cash per share “extra” on the balance sheet that I haven’t yet added in the above equations). And then there is the Bloomberg equation that shows a value north of R26 per share, but as I’ve said, Bloomberg’s view of the risks of investing in Africa is perhaps slightly optimistic, and hence R26 may be overestimating the value of CIL given what I know at present.

CIL is probably worth around R22 at present, with significant upside if they manage to grow at the sorts of double-digit rates they have done historically while possibly lowering their borrowing costs. BUT, growth must happen at a higher ROCE than has been the case historically.

Encore

CIL has been issuing new shares at a compounded annual growth rate (CAGR) of 11.06% for the last 5 years. They have done so to keep the balance sheet mix between debt and equity at prudent levels (Net gearing is a conservative 16% as of 31 August 2016).

But, that still doesn’t mean I like rights issues – I really don’t. They tend to make a company bigger but often have an adverse effect on the value of the business. It does not help if the pie gets bigger and bigger but the slices get smaller and smaller at an even faster rate – nobody but the management team gets economically fat as a result.

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@Charl . Thank you for the great article.

With the Rand being as volatile as it is (and likely to stay that way for at least another year or two if not 7) do you know where I could find out how much each construction/infrastructure company on the JSE is hedged against the Rand??

Thank you

Hi “Go Long”, I really apologise for taking such a long time to reply, I forgot my password and the last few weeks have been quite hectic!

With regards to your question, you can have a look at the constituents of the Building and Materials sector (Construction) on the JSE – many newspapers have such a list. Then, what I like to do is to go to their websites and the to the annual reports or presentations. There you will most likely find a breakdown of the different percentages they earn in different currencies. I hope that helps.

Charl

End of comments.

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