A Quality Company That Merits A Premium, At A Discount - Neurones SA

Now and then I like to spend some time searching for "quality" companies. Simplistically, I consider a quality company to be one that is likely to earn excess returns on its capital for a long period of time. So long as these excess returns on capital can be maintained and earnings can be retained and reinvested at these rates, attractive shareholder returns are nearly a foregone conclusion. A company that can invest existing capital and the retained portion of future earnings at attractive rates will see its intrinsic value rise, and the share price will follow in the long run.

Besides returns on capital, I employ a few other filters while seeking quality companies for investment.

Cash Generation - Quality companies consistently generate cash flow from operations. Ideally, cash flow from operations exceeds net income over the cycle, indicating a low level of accruals. (Consistently lagging cash flow from operations may indicate that a portion of reported earnings are illusory, or that a company requires a high level of investment in working capital.) I also like to see companies that pay out cash to their capital providers and don't require equity increases or take on debt to fund operations. Companies that are self-financing from cash generated by operations are less sensitive to external factors like interest rates and equity valuations.

Conservative Capital Structure - As an equity investor, it is important to remember where one falls in the order of claims on earnings and assets: dead last. Employees, suppliers, lenders, lessors, the government and others all get paid before equity investors ever see a dime. For that reason, I look for companies with low debt and solid operating margins. Low debt reduces the chances that equity investors will be diluted or extinguished should the economy take a tumble and the company find itself short of funds. Low debt also increases a company's flexibility, allowing a company to make continue making productive investments when competitors are financially stressed and holding back. High operating margins increase the chances that a portion of sales revenue will still fall to the bottom line when sales are down or expenses are up.

Differentiated Product - Most companies that offer un-differentiated commodity products will not earn excess returns on capital through the full economic cycle. A prime example is producers of basic materials like iron ore or pulpwood. The moment that prices of these inputs rise to the point that producers begin making excess profits, competitors enter and a flood of new supply drives down prices to the point where no one captures excess returns on capital. Investors can do well by waiting for the inevitable bust and then picking up shares in companies left for dead, but holding these companies through multiple economic cycles will not typically be rewarding. Commodity companies blessed with talented management or unusually efficient operations may fare better, but these are the exception.

Companies that can differentiate their product offering in the marketplace stand a better chance of earning excess returns in the long run. Superior product features or service create a positive customer experience, which in turn creates customer loyalty and pricing power. Alternatively, a company's products can be so essential or ingrained in essential processes that switching costs are high. Companies like these also have pricing power, because it is easier for a customer to swallow a 2-3% annual price increase to than risk a business interruption by switching providers.

With all that said, why spend time looking for companies like these? For one, quality companies are more forgiving of investor mistakes. Probably most of us have made the error of buying into a moderate or even poor quality company at too high a price and felt the pain of seeing our investment permanently impaired. When buying into businesses of moderate or lower quality (and statistically, that's most of them) price is paramount. Buying at a substantial discount to intrinsic value is the only means of earning excess returns, because that intrinsic value may or may not grow and may even decline. Quality businesses, on the other hand, stand a good chance of growing their intrinsic values over time, making the purchase price less important. Consistent growth in book value per share year after year covers over a multitude of mistakes!

Before this turns into an essay, let me talk about a company I recently discovered that meets all my quality company criteria. This company has massive cash reserves and no debt. It generates free cash flow year after year, and invests this free cash flow at high rates, driving growth. It provides essential services and enjoys long contracts with high-profile clients. What's more, 78% of this company's shares are owned by the founder and the firm's employees. Despite all these characteristics, the firm's valuation is modest.

Neurones SA is a French IT provider. The company trades on the Euronext Paris exchange with the ticker NRO. Neurones and its staff of 4,000 provide all manner of technology services to France's A-list companies, including Societe Generale, Unilever, Lafarge and hundreds of others. These services include technology consulting, integration, infrastructure and applications. Neurones is a true entrepreneurial success story, begun by one man in 1985 and projected to earn $470 million in revenues in 2013.

Neurones' growth has been nothing short of spectacular. From 2002 to 2012, revenues grew at an average rate of 13.2% and operating income grew at 12.9%. Recent growth has cooled a little, but the company is still experiencing high single digit increases year over year. Here's a look at Neurones' last decade. All figures on the chart (and throughout the remainder of this post) have been converted to USD at 1 EUR: 1.38 USD.

As it has grown, Neurones has maintained its profitability. The company's 2012 EBIT margin was a shade above the ten year average. It's worth mentioning that Neurones' impressive growth record was achieved during a very challenging stretch for the French economy and for the world in general. Neurones grew right through the severe recession and looks to keep going.

Everybody likes to see growth, but growth is really only valuable if it results in increased earnings and free cash flow. Neurones passes the test, having increased its net income in tandem with its revenues. While cumulative net income to the parent company for the last decade was $134.45 million, free cash flow was $127.13 million. This indicates superb capital efficiency, as nearly none of Neurones' net income got tied up in non-cash investments in net working capital or fixed assets. Instead, Neurones' was able to use nearly all its earnings to add productive resources like additional staff, or to make small add-on acquisitions to increase its expertise and service offerings.

In the last decade, Neurones purchased and integrated more than a dozen smaller companies. These acquisitions have been an unqualified success, based on an examination of historical returns on invested capital.

From 2003 to 2012, Neurones's return on invested capital averaged 26.90%. This figure has held up even as the firm has nearly tripled its revenues and asset base, indicating consistently strong capital allocation policy and opportunities for reinvestment.

For the first nine months of 2013, Neurones' revenues are up 8.3% from the same period in 2012. EBIT margin rose to 9.3% compared to 8.6% for 2012.

The company also reported holding cash balances of $123.8 million against zero debt. That speaks volumes to Neurones' fiscal strength. Neurones has historically held significant cash balances and maintained a zero debt policy. While some would argue that avoiding leverage to this degree hampers returns, I think Neurones' strategy has provided it with the ability to operate through business downturns completely unperturbed, and to make opportunistic investments while other firms struggled with debt covenants and liquidity crises. At the end of 2012, cash and equivalents made up 36.2% of Neurones' total assets.

Neurones has strong potential for continued growth, excellent returns on capital and an ironclad balance sheet, but these qualities are not reflected in its market value. Neurones closed yesterday at €11.89/$16.41, with a market capitalization of $394.1 million. Net of cash, Neurones' enterprise value is $263.3 million.

Determining trailing EBIT takes a little more legwork. 2012 EBIT was $38.7 million. Based on the reported revenues and EBIT margins for the first three quarters of 2013, trailing EBIT has increased by $4.7 million to $43.4 million. However, a material portion of Neurones' income is attributable to minority interests. In 2012, minority interests' claim was 13.1% of Neurones' total net income. Being conservative and assuming that 15% of Neurones' EBIT is attributable to minority interests yields trailing parent company EBIT of $36.9 million.

With an enterprise value of $270.3 million, Neurones trades at an EV/EBIT multiple of 7.3. That's far too low for a company managing 25%+ returns on capital and growing at a high single-digit rate, with its entrepreneurial founder still at the helm.

Part of the humble valuation may be due to Neurones' relative illiquidity; despite its market capitalization, only about $87 million worth of share are free floating. On average, fewer than 8,000 shares changed hands daily for the last three months. Still, that's plenty of volume for a patient investor to build a sizable position over time.

The more significant factor in Neurones' low valuation is likely a perception of the French economy as troubled and struggling to grow. When investors mistakenly paint entire economies as "low growth," the actual high-growth companies within that economy can sell at unjustifiably low multiples. These perceptions do not last forever, and astute investors can take advantage by purchasing quality companies on the cheap.

Not many companies can truly grow profitably, but those that can are worth paying for. The long-term growth in book value per share that these firms can produce can reward investors with multiples of their original investments, without stressing about whether one has invested at a sufficient discount to an intrinsic value, the trajectory of which is anyone's guess. When one can invest in a quality company without paying up, so much the better!

No position. May initiate in the next 30 days.