Spotting a bargain on the JSE is not so easy

IDENTIFYING the good companies on the JSE is very easy. We all know which ones are successful and growing above average over the long term. The problem with these companies are that they are always quite expensive and you are always hesitant to buy them at hefty valuation levels.

Occasionally they encounter a headwind and you get an opportunity to buy. Then you are once again hesitant because you don’t know whether it is a permanent headwind.

Famous Brands is currently in such a situation. They experienced spectacular growth for many years, but this year it is different and there are a few changes.

They have taken on huge debt, cut the dividend and they have a new chief executive. The share price dropped 27 percent from R172 in October 2016 to R125 this week.

Taking a closer look at the reason for the decrease in headline earnings, it is a currency adjustment due to the fluctuations of the British pound.

Growth company

Famous Brands (FBR) acquired seven businesses in the financial year, including a UK business, their biggest acquisition ever, increasing their debt-to-equity ratio to 165 percent.

At the results presentation this week, new chief executive Darren Hele emphasised that Famous Brands is a growth company and therefore decided not to pay a dividend, the first time in 13 years.

The groups’ interest expense shot up to R132 million from the previous year’s R7m. This is mostly due to the loan of R2.4m to acquire British group Gourmet Burger Kitchen (GBK) with around 80 restaurants.

According to Hele, the timing of this acquisition was not ideal, since the transaction was concluded at an exchange rate of R17.54/£ and the rand subsequently appreciated to a level of 15.19/£. Is the business still healthy? Stripping out non-operational items, it went very well with FBR. Operating profit grew by 18 percent. They acquired seven businesses in the last year, and this is where the changes are coming in. So far FBR was a franchise business, playing the role of the franchisor.

Transformed business

The most recent acquisition of GBK transformed the business into a physical restaurant owner. What else was there for FBR? Since the franchise market in South Africa seems quite mature, and they already own the majority of the big chains. The question is whether they can successfully do this transformation?

Hele always made a good impression, sharing the same vision and bringing it across in the same impressive way as his predecessor Kevin Hedderwick.

Bringing FBR skills to the newly acquired businesses can bring more efficiencies and profitability.

Despite difficult trading conditions the South African businesses did extremely well, growing by 18 percent. 192 new restaurants opened, while 220 were upgraded.

Hele said he was not comfortable with the high levels of debt and said plans were afoot to reduce the gearing (net debt to equity), and hinted that a rights issue might be on the cards.

Like all entrepreneurial and respectable companies FBR have pursued global food brands to buffer against local headwinds.

Moving from being mostly a pure South African play, Famous Brands shelled out R2.1 billion for GBK.

Prospects

To simplify their valuation: if they just resume their earnings from February 2016 (541c per share), the forward price/earnings (p/e) ratio is 24, and if the earnings is only 10 percent higher, the forward p/e is 22.

I am happy to buy a company with an exceptional business model and growth potential at such a rating. They have now diversified properly by adding the UK businesses to their portfolio, and with our currency that will probably keep on depreciating over the long term, it will add to their prosperity.

At the current level of R133 you can consider buying at least half of your Famous Brands holding, wait and see if there will be a rights issue and the share going back to the R120s, and then buy more.