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17 February 2014. Be greedy when others are fearful. I mentioned before that I didn't invest much in Esor because of the uncertainty I had with my estimate and because I wasn't sure whether there would be more losses from the Civils division. The fact that the price has dropped makes those less of an issue, and I have bought some Esor at 42c and 43c. What concerns me is that its results are going to come out soon, and there's the possibility of insider trading having driven the price down. And then Bernie Krone isn't buying anymore (or is his powder dry?). Still uncertainties, as there always are in the investment world, but we do know that the price is more attractive. Late in the day today a couple of huge buyers emerged with bids for over 1m shares at each of 40c, 41c and 42c.

I mentioned in November that I had completely sold out of Accentuate at a 100% profit over the 11 months I'd held it. I get a lot of things wrong, but was happy to get that one right as it was a larger bet. I didn't expect us to have another dance so soon after we'd enjoyed the previous one, but its price subsequently came screaming down getting my hopes up of of buying it again - but it wasn't to be, and the price has gone up a bit again. One can have a lot of fun with an illiquid share like that.

Guy Toms bought a bit more of Prescient. I'd love to buy Prescient shares, but it seems that management are big buyers at a level where I see value, but not enough to buy. A pity.

Terry Bantock bought a tiny bit more of Buildmax at R2.59. I'm not going to buy more at current levels.

Better to buy a good company for a fair price, than to buy a fair company for a good price

It is far better to buy a good company for a fair price, than a fair company for a good price. Esor feels more like the latter than the former to me.

Somebody with knowledge about the industry, told me her concerns about Esor, and painted a rather bleak picture:

(a) The merchants that supply material reckon that Esor are not good payers & let their accounts go 90 to 120 days. This points to cash-flow problems.

(b) The merchants who hire out plant equipment to Esor say that they are late payers and often have to be chased for payment.

(c) Esor spent quite a bit on yellow plant, yet Esor has been selling second hand plant during 2013 at very cheap prices. So it looks like they needed cash in a hurry.

(d) Esor are a geotechnical company and yet they sold the jewel in the company to the British. They seemed to got a good price, but surely they are now deviating from their core?

(e) I see the group now as just another contracting company. The margins in the contracting section are not great and they seem to be a new comer who has to almost start at the beginning. So what does this make of Esor?

My reply:

- (a), (b) & (c) are all about cash-flow problems.  This is probably why Esor held back so much of the cash from the sale of geotechnicals, and hopefully this has resolved it for them.
- (d) Yes, agreed, they've deviated.
- (e)  Yes, the company seems higher risk than before. What is left? The Civils, Pipelines & the new Development division. Historically the Civils & Pipelines have made profits, albeit cyclical.  The big question is whether they can return to the long-term average.  That Bernie Krone invested R800k in the business on the 2nd December 2013, seems to imply there's a good chance, but then again he's invested before and been wrong before.

Esor selling its Geotechnical division should make the company higher risk but easier to analyse in the future. In the meantime it creates the difficulty of having to carve out the correct profit for the remaining parts. Whilst I'm sometimes willing to do the work to analyse complex beasts like Grindrod, my natural preference is for simple companies. I demand a higher margin of safety if there are parts of a company I feel I don't understand sufficiently. On the other hand, it's not necessary to understand every detail of a company - I don't need to know how to operate the heavy machinery lugging Esor's pipes around, to be able to decide whether or not to invest in the company. I believe in big picture analysis, and that the smart analysts know when to dive into the detail.

I think the best way of starting off looking at Esor is by studying the historic profit before tax of its 4 divisions, as it allows us to guestimate long-run profit of these volatile income streams (and to exclude the Geotechnical division from our estimate of owner earnings). The further back we look, the further forward we can see. I've started in 2009, as the period then includes a downturn as well as some periods of profitability.

Civils

The Civils division builds roads, bridges, township infrastructure, mining infrastructure, water reticulation, water towers, sewer reticulation, bulk earthworks, and waste water treatment plants. It has long-term contracts inter alia with Eskom, Bakwena Platinum Corridor Concessionaire, the Gauteng Department of Roads and Anglo Thermal Coal. It has recently expanded into Botswana. Esor have commented that profitability in the 6 months to 31 August 2013 was impacted by 3 loss-making contracts in the Civils division, which will be completed this financial year. These contracts apparently date back to the World Cup (although I don't understand why the losses are only coming through now), when work was scarce and margins very low:

• One of the contracts is near Marikana, where there's labour tensions, and productivity is low. In a Biznews interview Bernie Krone said that "it's the same at Kusile & some of the other contracts".

Looking at past profitability, it seems plausible that the last 6 months were an unusually poor 6 months, against the average profit before tax of R17m. Esor Civils has been positioned to benefit from growth in the social housing market & anticipated Government growth initiatives.

Order book at 31 August 2013 totalled R2.2bn, compared to R2.1bn for continuing operations at 31 August 2012.

Pipelines

Esor Pipelines focusses on the construction & rehabilitation of onshore pipelines, operating in the gas & petrochemical, water, stormwater & sewerage sectors. They work with pipes made from steel, glass fibre reinforced polyester, concrete, PVC, ductile iron, HDPE and fibre cement. Growth of Esor Pipelines over the last 2 years has generated a quality order book & profit. The division has entrenched a forceful presence in KZN (e.g. from Umgeni Water for the Umlaas Road & the Lower Thukela pipeline, and a sanitation project for the eThekwini Municipality), and is busy extending its footprint into Swaziland. The Shearwater group of companies was bought in November 2008, and was renamed Esor Pipelines.

Corporate

The Corporate division is responsible for finance, taxation, internal audits, risk, HR, payrolls and IT.

Long run Guestimates

The above numbers exclude inflation. Taking inflation into account it's not unreasonable to have the following estimates for the long-run profit before tax (each 6 months) of each division:

• Civils R19m

• Pipelines R11m

• Developments R1m (complete thumbsuck, as there's not enough history, one would hope they'd make up the first 6 months loss over the next 24 months)

• Corporate loss of R17m

(these are very rough estimates, and actual numbers will vary widely, as they have indeed in the past)

Geotechnical Division sale

On 18 November 2013 the Geotechnical division was sold for R500m, with the potential for an additional R150m over 3 years.

• R150m of the R500m proceeds from the sale of the Geotechnical division was used to pay a special dividend, leaving R350m.

• Some will be used to settle the outstanding debt on the high yield programme. A R202m high yield bond is mentioned in Esor's results to 28 Feb 2013. It's not clear whether it's the R202m which is being settled. But presumably it is. I estimate this will save the group R10m in interest costs every 6 months.

• It's not clear how the remaining R148m is being used. To kill 2 birds with one stone, I'm going to assume that it's used to pay the net deferred tax of R77m (this is conservative, as the present value of R77m is less).

• I'm going to assume the remaining R71m earns interest at 5%, so R2m every 6 months (notice rough rounding to the nearest million).

Then there's the possibility of another R150m in the next 3 years. No details are given, but presumably they would say if the probability was negligible of receiving this, so let's assume there's a 20% chance of getting this, which equates to R30m. Instead of assigning an income stream to this, I'm going to just add it to the fair value I calculate.

Depreciation & Amortisation

In the year to 28 February 2013, 194m was spent on capex, and in the year to 28 Feb 2012 R258m was spent on capex. The Board approved capital expenditure of R92m for the year to 28 Feb 2014. It's not clear how much of this relates to the Geotechnicals division.

It's not clear to me whether the depreciation/amortisation figure of R37m in the 6 months to 31 August 2013 is elevated as a result of the large capex in previous periods (although it has come down from R89m in the year to 28 Feb 2013), or too little because of its historic nature. The problems in this area of analysis are compounded by the fact that the cash flow statement isn't split up. I've left it as is in my calculations, but this is a major area of uncertainty.

Putting it All together

Adding up all the bits and pieces described above gives guestimated long-term earnings every 6 months (after tax) of some R19m. Assuming that a spread of 9.5% is required over the risk free rate, and 1% real growth in earnings going forward, we're looking at fair value of some 90c to 110c a share. At 42c this gives me sufficient margin of safety. I didn't invest too much into Esor, because of the uncertainty I had with the predictibaility of earnings and what the sustainable capex is, as well as the possibility that things may get worse before they get better (the loss-making contracts in the civils division haven't run to an end yet). In short, I don't have a lot of confidence in my estimate or that I'm timing my purchase for the bottom of the cycle. I'm also a bit concerned about the fact that Bernie Krone has got it wrong with previous investments into the company.

Unfortunately, at the moment, it seems it's the riskier, cyclical industries which are better priced. Hold onto your seats, because it's going to be a wild ride.

Yours in nervousness,
Rob

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