There are reasons for being optimistic about the 3i Group: the fact that the last set of annual results published 13 May were encouraging; the outlook and the implication of management change; the breadth of the companies business operations and opportunities.

First, a brief description: the 3i Group  (epic III)  was established in April 1945. So it is now a venerable leader in venture capital buyouts and private equity, as well as having stakes in quoted equities. It was as I recall first a private business run by commercial banks that eventually brought to the market in its present form. Basically, it manages portfolios of investments from which over the years, it has earned profits and cash flow. It is valued as an investment trust  on the basis of the changing relationship between the share price and the net asset value - basically its investments.. As a matter of share price history, the 3i share price reached a peak of 761p in 2007 and was 595p in mid 2008. It bottomed at 250p and then again at 252p. Last seen, the share price was 288.1p.

The last set of results for the year to 31 March 2010 published 13 May, showed a significant recovery from the poor outcome the year before. It also showed a significantly stronger balance sheet with net debt down to 8% in contrast with the 103% figure the previous year. The company had raised £732 million in a rights issue just under a year ago, with which it largely paid down debt. Assets were unquoted investments valued at £1.8 billion, loans valued at £1.39 billion and cash of £1.52 billion. A relatively small portfolio of quoted shares worth £312 million made up the total of £5 billion. Diluted, net assets stood at £3.21 billion. Profitable realization of investments in  2010 brought in £1.38 billion to add to the rights issue cash. Net debt came down from £1.9 billion to £258 million.

The board had clearly responded to the crisis by lowering gearing and maximising cash. It now looks a safer investment but with £1.5 billion cash to take advantage of new opportunities. That cash, at the recent market capitalization.of £2.65 billion, equals some 160p of the recent share price and 30% of the total portfolio of assets of £5 billion.

The report stated confidence in outstanding new investment opportunities over the coming three years. The company also reported unrealized profits of £458 million. They represent 17.2p a share – an unrealized potential net profit yield of 6.12% The Company suggests that because of its conservative method of valuation, that  unrealized profits figure was inclined to be understates. With a diluted net asset value of £3.21 billion and a recent market capitalization of £2.8 billion the shares at 288.1p stand at a 13% discount to assets that include a lot of cash.

It is also to be born in mind that 3i is no longer a company with assets solely in the UK. Of its investments, 31% are in Europe and 6% in Asia and 5% in North America. Arguably, with a now much more competitive currency exchange rate Europe should prosper again as an exporter. Meanwhile, in it looks as though we have turned the economic corner. Good value. BUY.

King Solomon’s Mind.

I have long known that stock markets are not a branch of that comforting Newtonian physics of equal and opposite reactions we were taught at school. In markets, there sometime are reactions and sometimes they are equal and opposite, but not always. That is because they are as much about group psychology as they are about financial and economic analysis. Markets are people en mass, whose moods in the time honoured terms, move from greed at one extreme to fear at the other.

In May, markets for a variety of possible reasons are known to succumb to fear and trembling; more folklore than science perhaps, but there you are! The headlined problems which seem to be currently spooking the UK equity markets are in pretty much the same problems that were known and understood in March and April: the Greek credit crisis; the Euro problem posed by those curly tailed Euro PIGS , Portugal, Ireland, Greece and Spain; the need to tighten the monetary pegs of the ballooning Chinese economy and the worsening of some kind of inflationary pressures like iron ore, petrol and domestic government taxation.  We do not need a magnifying glass to detect the big profits ready for the taking after the unstoppable rally in early 2010, as the real opportunity and motive for the correction we have just seen. In Europe the squabbling and irresolution of European Governments, was the trigger for the collapse in a market in month well disposed to bad news.

So is the fall in share prices a correction or a harbinger of a bear market and the “W” recession that some have been yearning for? In my opinion there are solid reasons to be cheerful. So hit me with your rhythm stick!

The fact that the Euro reached a four year low against the US dollar (at a neat 1.234 dollars per Euro) and a nine year low against the Yen may be viewed as largely bullish for European economies medium and longer term. It has solved a big problem. The Euro was for too long made a proxy for that well remembered store of value, the vanished Deutsche Mark. That made it hard for the less industrially and commercially efficient Eurozone member states to find enough buyers for their goods and services outside the European Union. Now, that part of the problem has been solved - leaving inflation and interest rates as a potential issue for the future.

Next, the feared "contagion" of yet another banking crisis stemming from Greek bonds to Portuguese and Spanish bonds (Europe’s answer to the US sub-prime mortgages debacle)  has at last been addressed by the creation of the “stability fund” after a bit of slap stick, head over heels, pastry throwing hysterical political play acting in Europe.

The Eurozone is not a truly integrated monetary banking system. It was built as beautiful house high on a hill called Hope, but one with weak foundations and no proper fiscal plumbing; no governing budgetary control and no “lender of last resort” mechanism for central bank lending to commercial banks when they get illiquid  - as banks sometimes do. Now it has one in the form of the emergency stability pact. 

Over in the Middle Kingdom, the Chinese authorities are reducing credit. Bad for those with bull positions in Chinese property and mineral shares but not a deeply worrying a problem for the rest of the world. The Chinese are merely planning to grow their economy by 8% this year rather than 10%. If that is bad news, and things go to plan it’s the best kind. Once again, this was not “new” news. It was something that markets decided to act on in the Merry month of May. Just has they have resurrected the long term permanent problems of the Korean peninsular as something to worry markets with again.

Beneath all the headlines of waltzing angst, sturm und drang the outlook for the real economy is satisfactory for potentially profitable equity investment, for reasons explained in recent editions of the UK350. The US has escaped recession and expected to continue its recovery and the developing world economies will continue to develop at a still snappy pace. But the arrival of Mr. Osborn with his immediate cutting off of government spending life support to the weak UK economy, struggling for breath and life, must give rise to some degree of uncertainty until he proves he was right. However, as facts alter cases thhis early start as a response to the fever pitch conditions in debt and currency markets looks time perfect. At least managers of business will know a bit more a bit quicker where they stand for investment purposes. Let us hope it does not dent consumer confidence. Inflation in the UK is rising  again, as was officially predicted some months ago. It was also predicted that it would subside again in the Autumn given the spare capacity in the UK economy and the inevitable deflationary tendency of government cuts. The UK has short term lost devaluation advantage against Europe, so it must short term rely more heavily on the US and the dollar area countries as well as the Far East for export lead demand for British goods, services and employment.           

Having anticipated the probability of weak markets in May I remain objectively optimistic for the longer term although there is clearly a weakening in confidence in the bond and banking sectors. In my opinion, this is not the time to be selling shares. Rather it is the time to be looking for value as I suggested a month ago when anticipating possible market retreat.

Robert Sutherland Smith.

Updates

Big Yellow.

Tipped as an update last Autumn at 329p Big Yellow (BYG) the self storage company produced good results for the fourth quarter of its year to 31 March 2010, beginning recovery from the appalling results of 2009. Revenue was flat for the year but up 5% in the final quarter, which is normally the weaker one. Storage is back up to the 70%. level of capacity last seen in 2007. Big Yellow management think that can be increased to 85% in the medium term providing a lot more earnings. Last year the company got its customers from those moving house (57% of the total), those affected by ‘life events’ (23% ), those needing vacate a spare room (10%) and business needs (10%).  The company’s Net Asset Value was 453p and estimated to increase this year to 480p putting the share price at 318p at a discount of 33% to this years estimated assets. The equity is conventionally valued as a property play and thus looks very cheap given that those estimated attributable property assets are worth 51% more than the share price. A buy at 318p. BUY.

Yellow Group.

Yellow Group (YELL) the Yellow Pages Directory business was tipped last January at 39.3p for several reasons. They included the benefit of the cash from the rights issue and the modest enlargement of the company’s capital base, the consequential reduction of debt and the simple view that gearing is a benefit when recovery commences in contrast to what it does when demand goes down. What the company’s large gearing did for it in the recession would be reversed in the upturn. Most of those expectations were reflected in the figures for the last year to 31 March 2010, published earlier this month. What was not in my expectation was the synchronised resignation of the CEO and the CFO. In a market already gripped by May time risk aversion in the bond markets, this was enough to spook the shares. The normal volume of dealing in the shares jumped as some investment bank or broker somewhere persuaded an institutional fund manager to dump stock. Follow the tip at 39.3p the shares rose to 60p. The share price, last seen, was 33p.

The retiring CEO  John Condron who has been with the company for thirty years and now 60 announced his intention to retire in next year time. The CFO who is 48 and been with the company ten years, evidently decided that it would be appropriate to make the break at the same time having renegotiated the companies loan facilities and raised more capital through last summers rights issue. I can not see into their minds, but they have had a very tough exhausting couple years. In any event, I understand that they have agreed to continue in office to allow for successors and in the case of the CEO, to allow time for an orderly handover of the reins.

In my opinion, the figures were encouraging from a number of points of view. First, revenues in Q4 to March were better than budget. For the year as a whole, revenue fell 11.5%. Within that “on line” sales revenue rose 13% to now account for one fifth of total group revenue at £415. Of total US sales ($ 1.68 billion) internet accounted for just under 16%). Of UK total sales (£608 million) it was just under 29%. Group sales fell 12% to £2.12 billion but reported pre-tax profit was £70 million in contrast to the previous loss of £1 billion. Last year, earnings were a positive 3.4p against a stunning earnings loss of 124p 

The company did well last year in cash flow terms. Operating cash flow was £620 million; free cash flow before exceptional charges was £346 million. Net debt was down by £1.1 billion although it was still a whopping £3.1 billion at the year end which the company plans to further reduce with cash flow.. 

So is there value here? In my opinion yes! First the company is selling on two times the revenue it gets from internet sales alone and they are growing strongly. With total sales of  £2.12 billion those who buy the shares now will get sales revenue per share worth  84p a share; two and a half times the current share price of 33p. At that price, the equity is selling on 1.34 operating cash flow, 2.4 time free cash flow; 2 times internet sales revenue 9.7 times last year’s  historic earnings per share. Net asset value was (admittedly all intangibles) 59p. Despite the massive net debt of £3.1 billion gearing a market cap.of  £883 million, I think that selling the shares at this rating as bonkers. In the absence of finding any evidence to support the alarmist reaction to the notification of resignation within the next year, I make the shares a risky buy because of the gearing. If recovery in customer demand has just turned a corner then such gearing should be a  powerful enhancement to profits and cash flow growth in the next two years. I note that one analyst close to the company is pencilling in earnings per share of 7p for this year –  more than double this year’s earnings – putting the share on that estimate and forecast, on a forward price to earnings ratio of 4.7 times.  Even if that proves a touch optimistic the shares are still good value. At 33p a  BUY. 

Vodafone.

Vodafone (VOD) has just published its figures for the year 31 March 2010. Sale rose 9%, Pre –tax profit by 107%, earnings by 181% and the dividend by a handsome 7%. It also retains under the pillow, its big US Verizon investment which some fine day will produce monetary value for Vodafone shareholders. On an historic dividend yield 6.4% on a share price of 129p.  just about twice covered by earnings, the shares are a buy on yield grounds alone, particularly when you note that the Vodafone dividend has grown at an average annual compound rate of 8% in the last four years. The shares were last tipped at 113p in June 2000. Making a total return (dividend and capital gain) of an estimated 21%, HOLD.   

ROBERT SUTHERLAND SMITH