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The following segment was excerpted from this fund letter.
By Rudi van Niekerk
Argent Industrial (OTCPK:AILTF)
I have discussed Argent in several of our previous letters and commentaries. As a refresher: Argent is an industrial conglomerate with about 24 underlying operating units across South Africa, the U.S., and the United Kingdom. Operations include steel-based trading, steel product manufacturing, security gates and fences, window shutters, bespoke trolleys for traditional and e-commerce retail, fuel storage and dispensing systems, concrete building products, and roll-over protection bars for construction machinery.
Formerly a low return value trap, the company has been undergoing an unnoticed transformation over the past few years. Since a new strategic shareholder stepped in, Argent has been optimizing cash generation, disposing non-performing assets, acquiring high return assets, and buying back shares.
As expected, Argent’s recently reported full year results (for the year ended March 2022) were excellent.
Over and above the ongoing share buybacks, Argent also declared its first dividend since we acquired our stake in 2019, indicating that these two ongoing programs will return 30% of profits to shareholders annually. Trading at a 4 PE and 62% of book, Argent remains an unappreciated gem.
I asked my colleague, our analyst Hans Koetsier, to do a write-up of his take on Argent, explicitly providing his own view independent of my assessment. His write-up follows this commentary. We left it mostly unedited to preserve the authenticity. I think he did a great job.
By Hans Koetsier
Argent Industrial (OTCPK:AILTF)
Few listed entities manage to pivot from a commodity-type cyclical business into a business that provides sufficient inflationary resistance on its product offering to protect inflation-adjusted returns on capital. Even fewer grow nominal profit after tax at a CAGR of 31% over 4 years whilst maintaining a cash conversion ratio of >100%, dutifully repurchasing 43% of outstanding shares over the same period with effectively no net debt employed in operations.
Almost no business with these characteristics enjoys management with the ability to allocate capital in a manner congruent with shareholders’ interest for prolonged periods of time. If such a business is found, the probability that its operations are focused on an industry as mundane as steel and steel-related products is exceedingly low.
Argent Industrial Limited is an industrial conglomerate with 24 operating units, operative in South Africa (15 units), the United Kingdom (8 units), and, to a lesser extent, the United States (1 unit). These operations include steel-based trading, steel product manufacturing, security gates and fences, specialized trolleys for traditional and e-commerce retail, fuel storage and fuel dispensing systems, concrete building products, roll-over protection bars for construction machinery, and custom-made door and window shutter systems, amongst others.
The product range includes many consumer brands familiar to South African residents, such as Xpanda, Jetmaster, etc. These products inherently enjoy very low risk of technological obsolescence, derisking Argent’s revenue streams, and their largely consumer-facing nature allows the company to pass pricing pressure on to consumers if necessary (e.g., due to inflation).
Argent has not always been the beneficiary of a rational capitalists’ approval – the company had a history of persistent low returns on capital and poor capital allocation, and was exposed to wild fluctuations in profit after tax due to its reliance on steel trading and steel prices. In 2018, the company wrote down excessive amounts of intangibles (book value now represents a fair to conservative reflection of the realizable value of net assets) and commenced a program of optimizing cash generation by disposing non-performing properties, businesses, and other assets and acquiring high-return assets in the UK and South Africa.
This project resulted in Return on Average Equity rising from 4% in 2017, to 16% in the most recent 2022 fiscal period – a direct result of earnings-accretive acquisitions that did not require increased capital employed in maintaining operations. The rapid reduction in issued shares (owing to the launch of an aggressive share repurchase program) allowed shareholders to be double beneficiaries of rational capital allocation, initially on an operational level and subsequently on an ownership level. Since 2019, earnings after tax enjoyed a CAGR of 31% whilst EPS has grown by 48% annually.
In short, management followed William Thorndike’s observations in Outsiders almost to the letter.
A prudent, and somewhat cynical observer would do well to heed the warning Keynes issued in a review of Edgar Lawrence Smith’s book, Common Stocks as Long-Term Instruments, that, “It is dangerous… to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was”. The fact that Argent’s management team was responsible for the historic persistently low returns on capital has not changed, and they do remain stewards of shareholders’ assets.
However, around 2018, a new strategic shareholder stepped in to expound the virtues of what Munger calls the “cancer surgery” approach. This refers to the process of entering an underperforming business with one (or a few) cash cows which has their collective performance diluted by other low-return businesses, and methodically exiting independent operations that have low-returns. Proceeds from these exits are subsequently re-allocated to high-return operations or returned to owners via dividends or share repurchases. Argent has done both and, in the process, diversified their operations to the United Kingdom, thereby hedging currency risk implicit in the emerging market South African Rand (ZAR). Recent history proves this program was a success, but the sustainability of the approach should be scrutinized.
Management has provided shareholders with good results since employing the new strategy, having achieved a tripling in share price over the past 5 years (without enjoying any valuation margin expansion – the company trades at a 4 PE ratio at the time of this writing). Common sense dictates that past results would be incentive enough to ensure continued managerial compliance with the newly instituted policy of rational capital allocation. However, success often breeds complacence.
Therefore, an institutionalized incentive structure is often required to ensure that the program is sustained. The group’s remuneration policy provides long-term incentives to executive management based on what is termed “Group Value Unlock” with the objective “To unlock inherent value within the group companies and properties by selling, partnering or realigning entities to extract funds for offshore acquisition or paid out as dividends.”
Such dividends include cash dividends and share repurchases, of which 30% of annual earnings is set aside bi-annually, exclusively for this purpose. The policy contains provisions which allow executive directors to be awarded for achieving sales values that exceed realizable net asset values as carried on the statement of financial position. In the short term, profitability bonuses are allocated based on reasonable outperformance of profitability targets that we agree with.
The above narrative is unnatural for an analyst tasked with fishing out disconfirming facts and evidence that negates a portfolio manager’s initial investment thesis. Argent is a nightmare for an analyst tasked with uncovering patent or latent weaknesses or risks inherent in the business’ operations. However, there do remain risks associated with the continued success of management’s operational and capital allocation competence.
Argent is trading at a low valuation, which increases the level of managerial conviction shareholders require as justification for purchasing new business units at higher valuations. A loss of focus in the acquisition strategy could have further tangible effects on future returns on employed capital. We maintain a schedule on the performance of all previous acquisitions made since 2018 and, so far, they have all been earnings- and value-accretive.
Furthermore, all UK and SA acquisitions have been in-line with management’s industry expertise. The ability to raise prices of consumer-facing products has not been stress tested; however, management remains adamant that they are positioned well for an inflationary environment.
The collective performance of Argent’s shareholders will be a product of management’s ability to continue to execute on their promises of selling redundant or low-return assets, finding earnings accretive acquisition targets, and continuing with share repurchases at reasonable valuations or, alternatively, by returning excess funds via cash dividends. These metrics will be closely monitored.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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