A European net-net with a P/E of 2x and African upside

It's not often a stock like Conduril is found; they are almost the perfect value investment.  A P/E of 2x, a ROE of 14%, trading at 42% of NCAV, and they're exchange traded on the NYSE Euronext.  Of course the company isn't perfect, but what company is at this low of a valuation.  They are located in Portugal (half of my readers just closed their tabs), they do business in Africa (the other half leaves) and they're family owned (crickets).

Quick Thesis

Conduril is a family owned company that has operated profitably in Portugal and abroad for the last fifty years.  They're consistently ranked as one of the best companies in Portugal.  The following items just don't seem to fit a well renowned company:

• Insanely cheap valuation
• P/E 2x
• EV/EBIT < 1x
• P/B .25x
• A return on equity of 14%
• A NCAV of €47.24/sh
• A consistently strong earning power, six year average EPS €11/sh

Background

Conduril (CDU.Portugal) is an engineering and construction firm located in Portugal.  The company is owned by the Martins family.  The family is related to the Amorim family which owns another Portuguese investment of mine.

The company bids for and supervises large scale engineering work such as hydroelectric dams in Africa, or the construction of new rail lines in Spain.  The projects can take years to complete and cost hundreds of millions of euros.

The company employes 2169 employees spread across Portugal, Spain, Angola, Mozambique, Botswanna, and Morocco.  The majority of Conduril's work is in Africa (67%) with the rest in Portugal and Spain (33%).  The company has long operated in Africa and is well known and respected in the area.

The company trades in Portugal and publishes their financials in English on their website.  The stock doesn't trade often, but there are a lot of shares available at the current price.

Conduril is the type of company I was thinking about when I read the book Africa The Ultimate Frontier Market.  They have European roots, some business in Europe but most of the company's operations are in Africa.  The shares are easy to purchase in Lisbon and don't require any crazy African bank accounts or brokerages.  The company is also subject to better regulation in Europe than Africa, yet at the same time is very exposed to African growth.  While Conduril isn't a pure African investment at 67% of their revenue they're most of the way there.  And being able to buy this African growth cheap is just a bonus.

What's the problem?

Conduril is clearly cheap, both on an earnings and asset basis.  One question I always like to ask is "why is the company cheap?"  Conduril has all of the obvious factors such as being located in an out of favor country, doing business in an emerging market, and having a large majority shareholder.  They're also somewhat illiquid and trade fairly infrequently.  Combined with all of these factors is the company's accounting is a little different than usual because they use percentage of completion to account for long running projects.  As a result receivables appear large and forboding, and operating cash flow doesn't always match net income year to year.  To make sense of this let's look at receivables first.

The best way to depict this is with the net-net template:

Conduril is a company with a €32m market cap, and an accounts receivable that's 8x the size of their market cap.  What's glaring is if this value is discounted NCAV drops from €47.24 down to €3.56.  The difference in those two values is the hope that the company can collect on their accounts receivable.

The receivables are a scary number, and it's easy to see a large number like this and walk away, but I think that would be passing judgement too quickly.  As I mentioned above the company does large scale construction projects that span multiple years.  Clients on large construction projects pay similar to how a homeowner pays a local contractor.  A deposit to start, a portion as some work is completed, and the rest upon completion.  Conduril gets paid in a similar manner.  The company uses percent of completion to account for revenue recognition as a project is underway.  This method attempts to match revenue with approximate costs through time.  Unbilled revenue is recorded as an account receivable, and likewise cash paid upfront but unbilled is recorded as a liability.  Conduril's statements are consistent with this sort of accounting, they have a large accounts receivable, and a fairly large "Advances from clients" liability.  As a project works towards completion the receivables will move to revenue and the cash advance liability will be reduced.

I looked at Conduril over a year ago, tried to get shares but was unsuccessful.  At the time the item that concerned me wasn't the receivables, it was the cash flow.  I wondered how could a company that earned €19m in accounting profits only have €3.5m in operating cash flow?  My failure to understand exactly how the company accounts for projects led me to think this was a company on the edge of a fiscal meltdown, or was run by shady operators.

The percentage of completion method of accounting captures an approximation of how costs and revenues might be spaced in a project, but it doesn't have any bearing on real world cash flows.  In Conduril's case their cash flow is lumpy, very lumpy.  Over the past six years they've had years where they brought in €98m in cash, and years where operating cash flow was only €1m.  Just looking at a single year can lead to incorrect conclusions.  Since Conduril is constructing and managing over multi-year intervals it's helpful to look at their cash flow on a longer term basis.

I want to thank a reader for assembling the following stats, we've been going back and forth on Conduril after I mentioned them in my Africa book review.  On a six year basis the company recorded net income of €121m and operating cash flow of €98m.  Cash flow is super charged in years when projects are completed, then much lower until the next completion.  This might make some investors uncomfortable, especially ones who love smooth trends, but Conduril's cash flow pattern is a byproduct of the industry they work in.

Catalysts

Everyone loves catalysts.  If I put the word catalyst in a headline I will have almost double the readers for a post.  It's silly, but it's true, supposedly patient value investors want some sure sign that value will be recognized in a short period of time before investing for the long haul (notice the irony).  No one wants to be told they need to wait six years before they realize their return, but it is possible.  I have no idea when value might be realized with Conduril, but there are two things that I find hopeful.

The first is in 2009 the company petitioned the CMVM (Portuguese regulator) to go private and were denied.  The company stated in their annual report they didn't see the benefit of being public.  It's unclear whether they might try again in the future. The company realizes they aren't deriving much of any benefit from being public and would prefer to be private.  Going private could result in a sizable premium paid for the outstanding public shares.

The second is the company mentions in their annual report that they have a 600€m backlog.  The company is expanding into the Cape Verde market and is expecting business to rapidly grow in Africa.  I'm not sure if this is necessarily a catalyst, but it's more of a sign the company expects business to remain strong.

Conclusion

Conduril isn't the type of company I'd concentrate a portfolio around, but they're almost too cheap to not own.  I find safety in the large discount to NCAV and the discount to earning power.  The company has a thriving African operation which could benefit from growth on the continent over the next decade.  This stock isn't going to give a fantastic return in the next six months or even in the next three years, but for the patient investor I don't think you can go wrong buying a piece of Conduril.

Talk to Nate about Conduril

Disclosure: Long Conduril