Rummaging through the sharemarket looking for value, it’s hard not to come across environmental and engineering services group Cardno (CDD).
The stock price has fallen 50% since September last year, and it now trades at 8 times pre-tax operating earnings (on an enterprise basis) and has a juicy 10.9% dividend yield.
A quick glance at the income statement shows that profit has fallen 14% from a 2012 high, which doesn’t look too bad when you factor in a difficult environment in mining and oil and gas. Service providers are more vulnerable to a downturn, so some impact is to be expected.
But I’m not convinced this is a bargain. It’s often said that the balance sheet is not important for professional services businesses because the earnings power resides in intangible things that won’t appear on the accounts. Stuff like people, relationships, reputation, systems and technology.
Sure those things are important, but you always want to look at the balance sheet – at the very least to see how much debt the company has. At Cardno the balance sheet has a very interesting story to tell. Look at the capital employed (net assets plus debt) over the past 5 years.
Since 2012, the company has employed an extra $400m capital, and is earning $20m less. In that context, earnings performance that seemed mildly disappointing now looks disastrous. Return on capital has fallen from 17% to 9.5%, and management is making big acquisitions to try and fill the gap.
If this is as bad as it gets Cardno could be good value. But, for a serial acquirer, deterioration in underlying performance is often the first sign of fundamental problems. Has the company been obsessed with short-term earnings growth, and paid too much for a bunch of mediocre businesses?