Cautionary tale in coffee
Opinion & Analysis
OPINION: In a month or two the NZX will open its new market for small companies.
This will be a good thing. Once it gets going there should be more businesses listed, capital raised, business growth and investment opportunities.
But investors will have to be careful.
The combination of small companies and a looser disclosure regime will make NZX's mini-me a riskier place to shop for shares than the main board. Even now, the smaller end of the listed market features a few companies with all the commercial appeal of chopped liver.
In mitigation, the stock exchange will commission publicly available analyst reports on these companies to help investors understand what they could be worth.
Again, this will be a good thing. And again, investors will have to be careful.
To get an idea of what to expect, let's look at an analyst report on Cooks Global Foods issued by research firm Edison a couple of weeks ago.
Edison is bidding to be a provider of analyst reports for the new market while Cooks, with a current market capitalisation of $49 million, is the sort of company the new market is aimed at.
When Cooks published the report to the NZAX it went with the headline "Edison Report values Cooks shares at $0.275 per share".
At the time, Cooks shares had last traded at 17c a share, so the report appeared to say they were worth 62 per cent more than the current market valuation.
So Cooks is a screaming buy, right? Er, no.
While Edison's report does indeed involve a 27.5c a share valuation, it also has 16 pages of useful and readable information explaining that a great deal must happen before Cooks will be worth that much.
The company's main business is in coffee shop franchising, but not in New Zealand.
Cooks, previously a listed shell, last June announced a reverse takeover of a local company owned by Stuart and Lewis Deeks, two brothers who had built up and sold the New Zealand franchise for the Esquires coffee house chain.
Although their sale of Esquires in 2012 had a restraint of trade in New Zealand, the Deeks brothers had continued their involvement in Esquires, and the Cooks deal bought the Esquires franchise rights for all countries other than New Zealand, Australia and Canada, where the brand was founded.
Cooks has yet to report any financial results with Esquires, but Edison's report showed that as of February it controlled 78 of the 132 Esquires stores worldwide. The other 54 are owned by ASX-listed Retail Food Group.
It also noted the detail that although Cooks had now acquired the Canadian master franchise, the existing Canadian franchiser would get to run royalty free for the stores it currently operates. Cooks would only get fees from new stores it opened "in provinces and cities where the current operator is not present".
Edison's financial projection sees revenue for the 2014 year of $4.6m producing a net loss of $1.2m.
Clearly, this is a long way from numbers that would imply a value of 27.5c a share, or $71m.
The big value comes from Cooks's aim to build Esquires into a chain of 580 stores by 2020.
By that stage, Edison estimates, Cooks would have revenue of $32m and net profit of $6.9m.
There are several other assumptions Edison uses to arrive at its valuation, but in essence Cooks must add 500 more coffee houses to its network in six years.
Having visited an Esquires once, I personally doubt that target will be achieved. Figures on the UK market in Edison's report reinforce that view.
Cooks runs 28 stores in Britain, implying a market share of about 0.8 per cent. In 2012 its biggest competitor, Costa Coffee, had 1552 stores and a market share of 43 per cent. The number two player was Starbucks on 757 stores and the number three was Cafe Nero on 530.
Edison said Cooks's management believed a market share of 2.5-5 per cent was needed, which would require 139 stores and move it to number four in the market.
That's a lot of growth in a mature market with well-established competitors.
Edison's report is certainly helpful in explaining how Cooks works and what it is trying to do, but it doesn't attempt to analyse alternative scenarios. How likely is Cooks to meet its target? How much is it worth if it gets only halfway there?
As a result, I'd regard the headline valuation as optimistic rather than realistic.
Edison, based in Wellington but part of a London headquartered research group, was paid directly by Cooks for the report. I know of other small companies that don't pay for analysis in this way because they think it would not be seen as independent. However, Edison director Simon Wilson insists that although Cooks pays the piper it does not call the tune.
"Our process is completely independent. Our analyst puts together a draft report. It would get sent to the company for fact-checking only, but we have final editorial rights over what's published, which is crucial to our business model."
If a company had a problem with a valuation, he says, "we'd prefer to walk away from a contract rather than publish something we weren't happy with".
If Edison provides analyst reports for the new NZX market it will be paid by NZX and not the listed company, so the same issue of independence will not arise. However, the depth of the analysis is likely to be similar, reflecting the relatively low-cost nature of the deal.
The upshot is that the welcome arrival of public research reports shouldn't lull investors into turning off the brainbox.
As a footnote, Edison analyst Bruce McKay has been named as one of the accused in the Financial Markets Authority prosecution of key figures at Viaduct Capital and Mutual Finance.
Wilson said McKay, who had worked on the Cooks report, would not be fronting research reports "until we get clarification on that".
Tim Hunter is deputy editor of the Fairfax business bureau.
- Sunday Star Times