James Montier

Fortnox: A High Growth Small-Cap with High Profitability

Fortnox is, according to themselves, the leading provider of Internet-based applications for businesses, associations and accounting and auditing firms (a big part being their offering of accounting software). The business concept is to offer a wide range of Internet-based applications that are easy to learn and use, yet is powerful and feature-rich enough to meet most needs and wishes. Fortnox has been growing at a fast pace back since it was founded in the early 2000s.

Below a page from the 2015 Fortnox annual report with my own notes (I now see that I made a mistake when I wrote 2016 which is incorrect, should be 2015 and nothing else).

Cash Offer from Visma

On March 14, 2016, Visma made a cash offer to acquire Fortnox for a total purchase price of SEK 1,406 billion, or SEK 24 per share. To read the press release, click here.

In its quaterly report for Januari-March 2016 Fortnox disclosed a non-recurring item of approximately MSEK 1 for consultations, a so-called fairness opinion, in connection with the Visma bid mentioned above. The Fortnox Board of Directors have evaluated Visma’s bid by themselves, and from taking in a fairness opinion, decided to favour Visma’s bid.

Visma’s current bid puts a total value of MSEK 1,406 for the shares outstanding, or SEK 24 per share. On the same day as the bid was made public the share price rose from SEK 18.2 to SEK 23.9, an increase of +32%. With the value of equity at MSEK 1,406, almost no debt (only MSEK 0.5) and cash of MSEK 46 at year-end 2015 (compared to MSEK 52 per March 30, 2016) Fortnox has an enterprise value of about MSEK 1,360.

Re-Engineering Visma’s Cash Offer

Reverse engineering a certain valuation makes it possible to back out what growth is implied in it, as noted by James Montier:

So, if one can’t use DCF how should one think about valuation? Well, one solution that I have long favoured is the use of reverse engineered DCFs. Instead of trying to estimate the growth ten years into the future, this method takes the current share price and backs out what is currently implied. The resulting implied growth estimate can then be assessed either by an analyst or by comparing the estimate with an empirical distribution of the growth rates that have been achieved over time, such as the one shown below. This allows one to assess how likely or otherwise the implied growth rate actually is.

Let’s see what implied growth assumptions we get if we reverse engineer Visma’s cash offer per share of SEK 24, equal to a total purchase price of MSEK 1,406.

I have put together three different scenarios, all starting with earnings per share (EPS) of SEK 0.43 (calculated by assuming 25% growth in revenues in FY2016 and an operating margin of 20% with a 22% corporate tax rate). A discount rate of 10% is used in all the scenarios.

Scenario 1. Forecast period of 5 years with a compounded annual growth rate (CAGR) of 25%.
Scenario 2. Forecast period of 10 years with a compounded annual growth rate (CAGR) of 15%.
Scenario 3. Forecast period of 3 years with a compounded annual growth rate (CAGR) of 35%.

Scenario nr. 1 requires, except for the assumed 25% CAGR during 2016-2020, a terminal growth rate beyond 2020 of 6.76% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 1 valuation is shown in the table below.

Scenario nr. 2 requires, except for the assumed 15% CAGR during 2016-2025, a terminal growth rate beyond 2025 of 6.76% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 2 valuation is shown in the table below.

Scenario nr. 3 requires, except for the assumed 35% CAGR during 2016-2018, a terminal growth rate beyond 2018 of 7.20% to end up with an intrinsic value per share of SEK 24, equal to the cash offer from Visma. The numbers and the calculation of the reverse engineered scenario nr. 2 valuation is shown in the table below.

Discount Rates and Terminal Growth Rates

By altering the discount rate used we can solve for what terminal growth rate needed to get an intrinsic value per share of SEK 24.

See table to the right where different growth rates are shown for each of the three scenarios depending on what discount rate is applied, ranging from 8.0% to 15.0%. Depending on the discount rate used the growth rate range between 4.1% to 13.1%. What should be considered a reasonable discount rate as well as growth rate is up to each individual investor to decide.

The Trade-Off and Where to Go From Here…

I have not, and I do not, own any shares in Fortnox. Clearly, I was too late to the party and didn’t find this gem before Visma made its bid public. Without doing a lot more digging into this case it looks like Visma’s cash offer per share is reasonable. Of course Fortnox could go on and grow even faster. As always, the future is uncertain, but selling and taking the cash received to look elsewhere for new investment cases may be the thing to do. By reverse engineering the SEK 24 per share cash offer from Visma we are at least able to see what kind assumptions give this value.

Before making any further decisions about what to do, one would have to take a look at what levels of revenues that each EPS is derived from and analyze them to come up with an answer to whether they could be deemed reasonable or not. A quick look at revenues from the three different scenarios is shown in the table below. Scenario nr. 2 gives MSEK 395.8 in revenues in 2020, CAGR of 25%. This growth looks to be in line with the underlying growth in the industry (see link to analysis, in Swedish though, that I found that is referring to Statistics Sweden).

Before making any decisions one would likely want to have a closer look at revenues, both for Fortnox but also for the whole industry, to decide what levels could be deemed reasonable.

See tables below for some historical Fortnox key ratios.

Links

Disclosure: I have no position in the stock mentioned, and no plans to initiate any position within the next 24 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. This article is informational and is in my own personal opinion, and should not be considered investment advice. Always do your own due diligence and contact a financial professional before executing any trades or investments.

“Despite risk appearing to be one of finance’s favourite four-letter word, it remains finance’s most misunderstood concept. Risk isn’t a number, it is a concept or a notion. From my perspective, risk equates to what Ben Graham called a ‘permanent loss of capital’. Three primary (although interrelated) sources of such danger can be identified: valuation risk, business/earnings risk, and balance sheet/financial risk. Rather than running around obsessing on the pseudoscience of risk management, investors should concentrate on understanding the nature of this trinity of risks.” —Jamies Montier

The Trinity of Risk: A Tool In Assessing the Probability of a Permanent Loss of Capital

In his book Value Investing: Tools and Techniques for Intelligent Investment, James Montier writes that “…the permanent loss of capital can be split into three (interrelated) sets of risks: valuation risk, business/earnings risk, and balance sheet/financing risk.”

James ends the chapter and puts it all together by saying that “These three elements (intertwined as they are) can all lead to a permanent loss of capital. Ultimately, I would argue that risk is really a notion or a concept not a number. Indeed the use of pseudoscience in risk management has long been a rant of mine.”

The Trinity of Risk

Elements of the Trinity of Risk

Valuation Risk “Valuation risk is perhaps the most obvious of our trinity. Buying an asset that is expensive means that you are reliant upon all the good news being delivered (and then some). There is no margin of safety in such stocks.”

Business/Earnings Risk “As Graham put it. ‘Real investment risk is measured […] by the danger of a loss of quality and earnings power through economic changes or deterioration in management.'”

Balance Sheet/Financing Risk “Balance sheet/financing risk is the last of our triumvirate. As Graham noted: ‘The purpose of balance sheet analysis is to detect … the presence of financial weakness that may detract from the investment merit of an issue.’ In general, we have found that these risks get ignored by investors during the good times, but in a credit constrained environment they suddenly reappear on the agenda. We would suggest that rather than vascillating between neglect and obsession with respect to the balance sheet, a more even approach may well generate results.”

Element #1: Valuation Risk

“As Graham wrote, ‘The danger in … growth stock(s) [is that] for such favoured issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings.’ In other words, buying expensive stocks leaves you vulnerable to disappointment.”

“As Figure 11.1 shows, the US equity market is currently just below ‘fair value’ – not yet at truly bargain basement prices. I have no idea whether this major recession will take us to truly bargain valuations, but serious bear markets have normally only ended when we are trading on 10×10-year moving average earnings. This is consistent with the S&P 500 at 500!”

“This top-down valuation work is supported by looking at the percentage of stocks trading at Graham and Dodd PEs greater than 16×. You may well ask why 16×? The answer as ever lies in the writings of Graham who opined.

We would suggest that about 16 times is as high a price as can be paid in an investment purchase of a common stock … Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e. an average, earnings power. But it is difficult to see how average earnings of less than 6% upon the market price could ever be considered as vindicating that price.”

Element #2: Business/Earnings Risk

“The second source of risk from our perspective concerns business and earnings risk. As Graham put it.

Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.

In an environment which is increasingly being acknowledged as the worst since the Great Depression, a loss of ‘earnings power through economic changes’ must be a concern for investors. Graham warned that markets were ‘governed more by their current earnings than by their long-term average. This fact accounts in good part for the wide fluctuations in common-stock prices, which largely (though by no means invariably) parallel the changes in their earnings between good years and bad.’

Graham went on.

Obviously the stock market is quite irrational in thus varying its valuation of a company proportionately with the temporary changes in reported profits. A private business might easily earn twice as much in a boom year as in poor times, but its owner would never think of correspondingly marking up or down the value of his capital investment.

The challenge facing investors in this environment is to assess whether any changes in earnings power are temporary or permanent. The former represent opportunities, the latter value traps.

Keep an eye on the ratio of current EPS to average 10-year EPS. Stocks which look ‘cheap’ based on current earnings, but not on average earnings, are the ones that investors should be especially aware of, as they run a greater risk of being the sort of stock where the apparent cheapness is removed by earnings falling rather than prices rising.

Figure 11.4 shows the percentage of stocks in the large cap universe that have current EPS of at least twice 10-year average EPS. This serves as our proxy for earnings risk. In the USA, only one-third of stocks find themselves in this situation (as befits the country first into this crisis). The UK comes out as the worst on this measure, with 54% of stocks having current EPS of at least twice 10-year average EPS. In Europe and Japan, 42% of stocks are in this position. It appears to us that earnings and business risk are far more absent in these markets. The good news is that, given the lower valuations mentioned above, this may already be partially discounted.”

Element #3: Balance Sheet/Financial Risk

“The third of our unholy trinity of risks is balance sheet/financial risk. As Graham opines, ‘The purpose of balance-sheet analysis is to detect … the presence of financial weakness that may detract from the investment merit of an issue.’

Investors tend to ignore balance sheet and financial risk at the height of booms. They get distracted by earnings, and how these cyclically high earnings cover interest payments. Only when earnings start to crumble do investors turn their attention back to the balance sheet.

Similarly leverage is used to turn little profits into big profits during the good times, and many investors seem to forget that leverage works in reverse as well, effectively a big profit can rapidly become a loss during a downswing.

There are lots of ways of gauging balance sheet risk. Our colleagues in the quant team have long argued that the Merton Model and distance to default provide a useful measure of these dimensions. Being a simple and old-fashioned soul I turn to a measure that has served me well in the past during periods of balance sheet stress: good old Altman’s Z.

Altman’s Z score was designed in 1968 to predict bankruptcy using five simple ratios.”

Altman’s Z-score

Z = 1.2X₁ + 1.4X₂ + 3.3X₃ + 0.6X₄ + 0.999X₅

X₁ = Working Capital/Total Assets. Measures liquid assets in relation to the size of the company.

X₂ = Retained Earnings/Total Assets. Measures profitability that reflects the company’s age and earning power.

X₃ = Earnings Before Interest and Taxes/Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

X₄ = Market Value of Equity/Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.

X₅ = Sales/Total Assets. Standard measure for turnover.

“A Z score below 1.8 is considered a good indication of future problems. While only a first step, I have often found this measure useful for flagging up potentially troubling situations.

Figure 11.5 shows the percentage of large cap firms across countries which have Altman Z scores below 1.8. The measure obviously won’t work for financials or utilities so they have been excluded from our sample.

Roughly speaking, we find very similar levels of balance sheet risk across countries. Somewhere between 20 and 25% of companies appear to have Z scores below 1.8, suggesting a high probability of financial distress.”

Further Reading

See here for full PDF of the article FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY, Edward I. Altman (Published in The Journal of FINANCE, September 1968)
See here for full PDF of PREDICTING FINANCIAL DISTRESS OF COMPANIES: REVISITING THE Z-SCORE AND ZETA MODELS, Edward I. Altman (July 2000)
See here for the Wikipedia page about Altman’s Z-score

The Value Investing Trinity of Risk

So, use the trinity of risk when analyzing and assessing the probability of a risk of permanent loss of capital.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

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Business Analysis & Investing

Fortnox: Visma’s Cash Offer Re-Engineered