MS International - Owner earnings and intrinsic value estimation

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It’s important to examine MS International (LSE:MSI) with an income metric better than conventional profits after tax, which fails to properly consider the annual cash flows which end up being spent on fixed assets and in working capital items (inventory and receivables in particular) just to support the current strategic market position, and therefore turnover and profits. I’ll use Warren Buffett “owner earnings” approach.

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With owner earnings we are trying to obtain the earnings that, in future, would be left for shareholders after the managers’ use of the cash generated to pay for items of expenditure to maintain the strength of the economic franchise (e.g. additional capital items, additional working capital, marketing spend, R&D and staff training) and to maintain unit volume and to invest in all value-generating projects available.

Depending on circumstances, the owner earnings figure may be the same for every future year or on a steadily rising (or falling) trend.

Naturally, owner earnings are impossible to obtain with any degree of precision because many of the input numbers are merely educated guesses about the future.  Despite this imprecision it remains an important method for thinking through valuations.

Owner earnings analysis is about future cash available for shareholders to take out of the business.  But the only evidence we have available is past data.  We start with that, and then use qualitative analysis to judge whether to simply project forward the past pattern or modify the previous trend for future orientated thinking.

In the following we use what the company actually invested in new working capital items and in new fixed capital items, and what they spent on marketing, R&D and staff training etc. already deducted from the P&L.

What the analysis really requires is the amount necessary to maintain the quality of the economic franchise, unit volume and invest in value generating projects.  To start with we make the bold assumption that what was spent by the managers was also the necessary amount.

When we move to forward-looking analysis to value the firm we need to make another bold assumption on the real amount needed to invest in new WC, fixed capital items, etc., in the future.  The historical analysis helps us make that judgment.

In the table below I’ve been forced to exclude changes in working capital.  This is because, with MSI, changes in WC from one year to the next can be enormous because so much depends on whether a major customer has recently paid its bill or not.  Thus if the MoD happens to owe £10m to MSI at yearend the receivables number is very high.  In the next year receivables might be down dramatically.

Given that Group revenue between 2015 and 2019 rose from £45.5m to £77.7m (a 71% rise) we would normally – for other companies – need to allow for some additional investment in WC.  But in both these years, leaving aside cash, WC for MSI was negative.

It seems that as the firm grows it uses increasing amounts of supplier trade credit.  This trade credit then finances inventory, receivables and all other current assets. I’ll assume this pattern will be repeated in the future and so not deduct an amount for WC investment in the owner earnings numbers below.

Owner earnings in the past

£m              YEAR   2015   2016   2017   2018   2019   2020
Profit after interest and tax deduction 1,353 1,584 1,498 3,386 5,010 -2,491
Add back non-cash items such as depreciation, goodwill and other amortisation 1,434 1,669 1

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