In last Tuesday’s Money Morning, you may recall, I ran the numbers on troubled asset manager Blue Sky Alternative Investments Ltd [ASX:BLA]. Using consensus earnings forecasts for 2018, I came up with an estimate of intrinsic value of $6.05.
‘That compares to a current share price of $5.75. Realistically, though, the share price should trade at a much bigger discount. There is clearly uncertainty about the earnings of the company and uncertainty about its equity, or book value.’
‘The thing is, I’m not even assuming a decline in the intrinsic value of the company, which there surely will be after a public relations disaster like this.’
And sure enough, yesterday the company announced a whopping profit downgrade for FY18. Profit is now expected to come in at $20–25 million, down from previous expectations of $34–36 million.
Keep in mind there are less than three months of the financial year left. The fact that guidance has been slashed by such a large amount suggests the business is practically going backwards.
That’s not surprising. Given the bad publicity over the past few weeks, no one in their right mind would deal with this company. That means no growth in assets under management, no buying of alternative assets from vendors, and no selling of previously purchased assets, either.
Thankfully (for the company, not the investors) Blue Sky’s assets are illiquid and cannot be redeemed easily. This should ensure the company doesn’t disintegrate overnight. In other words, it has a large portfolio of assets under management that will continue to generate fees for the foreseeable future.
Still, who exactly was buying last week when the share price was north of $5.50? Seriously, I spent about 30 mins looking at the numbers and doing some high school maths that I managed to remember, and concluded the stock wasn’t worth touching with the proverbial barge pole.
It was plain to see, even for someone as simple as me, that this thing was radioactive. The numbers suggested value around $6, but who could trust the numbers.
That tells you — if you really needed any evidence — the market is far from efficient. Clearly, last week’s buyers were just punting, hoping they’d found the bottom. Perhaps they believed the selling was all the result of some evil, foreign short seller and that this was too good a bargain to give up?
I don’t know. That’s about the only thing I can come up with. Because everything else makes even less sense.
What is BLA’s value now that earnings guidance has been reduced for 2018?
Firstly, keep in mind that any estimate of value for a company with such an uncertain earnings profile is just that — an estimate. This is made harder by the fact that BLA recently raised $100 million in cash (at $11.50 per share — ouch!) and presumably that cash hasn’t been deployed yet.
Adding this newly raised cash to existing shareholder funds gives a total equity value of around $240 million at the end of the financial year. Assuming the company scraps into the bottom end of its guidance and delivers a net profit of $20 million. That roughly equates to a return on equity of 8.3%. Assuming the current payout ratio of 65% is maintained, and a required rate of return of 10%, I get an intrinsic value of about $2.30.
If all that’s a bit confusing, think of it this way: If you want a return from a business of 10% (that’s the required return), and the business only generates an 8.3% return on its equity capital (and distributes 65% of that as a dividend) what is the maximum you would pay?
You would clearly only buy the business at a discount to its equity capital. Why? Because if you bought at equity, or book value, you would only get an 8.3% return. Equity value is around $3.10, so you must pay less than that.
Now, there is a chance that the $100 million in newly raised cash will be invested and contribute to a future boost in net profit, which would increase the return on equity (ROE). Let’s make it easy and assume it boosts ROE to 10%. Since your required return is also 10%, that makes intrinsic value equal to the value of the equity, or book value, which by my estimate is around $3.10.
I should also point out that if you’re investing in a black box like BLA, you’re required return should be considerably higher than 10%. The higher the required return, the lower the asset value. So I’m probably being quite generous with my $3.10 per share valuation.
But even after yesterday’s 22% decline, the share price is still at $4.08. Perhaps more irrationally minded bottom pickers will come in and buoy the price for a while. But it’s hard to see how the stock isn’t going into the $3 range, and then the $2 range.
Know your valuations
The message here is simple: know your valuations. It’s all well and good to let a stock run way above a sensible estimate of value when the herd is on the loose. But when the mood turns, you’d be well advised to get out…and get out fast.
Because in these situations, where the market loses trust in management and the numbers, the price nearly always falls back to a conservative estimate of value…and then goes below it, as no one has any idea of where value lies.
Finally, to put this in clearer perspective. The market value of BLA is currently around $400 million, and the company expects to generate $20 million in earnings for FY18.
In other words, it’s trading at 20-times earnings! It should be half of that! The only question is how long will it take to get to $2?
Editor, Crisis & Opportunity