Calgro M3: Proving Quality

Calgro M3 (CGR) is a long-time favourite of mine, but I don’t think I’ve written much on it recently. Sometimes it takes years of quietly holding a stock for it to become a ten-bagger “overnight”…

Anyway, Calgro M3 has seen its share price decimated by a third this year and it recently released a trading update that looked negative at first glance.

But, the upside is in the detail…

Firstly, see an old article I wrote on Calgro M3 over here (Calgro’s FY 15 results) where I touch on their risk-based approach to managing their business.

Housing is actually a defensive product. Shelter is on the bottom rung of Maslow’s Hierarchy of Needs. Besides, everyone wants their own home, especially in South Africa where very few have this. Pretty much, if you can build them in the right places at the right prices, you can sell any amount of homes here. But, only if you can manage your way through the myriad of risks involved with property development at scale.

One of those risks is the large allocations of capital and massive overheads create huge operating and financial leverage that can create huge swings in a business’s profits (and losses).

After surviving the Credit Crisis by a small inch, Calgro M3’s management team set out to redesign the Group such that it could survive any massive cyclical speed-bumps thrown in its way. While project, client and product diversification are great mitigating factors, a key variable in this survival toolkit is the use of variable costs.

If you see this PR announcement from Calgro M3 (Calgro’s Response to Western Cape Drought) then you will notice that about a quarter of their production pipeline appears to have stalled due to the water shortage down in Cape Town. It is simple: If people are worried about having enough water to drink, you cannot go and use it to mix cement.

Going back to my point about risk-based management, Calgro M3’s trading statement recently came out noting that H1:18 HEPS are to be -27% y/y down.

So a quarter of lost product has led to a quarterly decline in profits. This is fantastic! What the hell, I hear you ask? Well, this demonstrates management’s risk-based approach to managing the Group and greatly buffers it against macro-winds. I.e. Calgro’s lost sales were matched by a lack of expenses (variable costs), such that a nearly 1-to-1 change occurred from top-line to bottom-line.

Let me rephrase this, just watch how Balwin Properties’ earnings react when its sales decline… It won’t be pretty.

Now, digging a little deeper into Calgro’s trading update one will find how their residential REIT joint venture (REIT JV) with SA Corp has trapped a bunch of profits on their balance sheet. These “future profits” can only be released to their income statement once the units have been completed, let out and revalued.

So what?

Well, if these profits were included in H1:18, then Calgro M3’s HEPS would have been +18% y/y higher! This is a massive jump. Not only has Calgro M3 survived a quarter of lost production, but it has swung its sales into an alternative channel that more than makes up for this loss…

Now whether you believe IFRS HEPS or Core HEPS, the point remains the same: Calgro M3’s risk-based approach to managing their Group is working. They are not just proving their bottom-line buffer against cyclicality, but their revenue stream diversification (i.e. Memorial Parks and REIT JV) is starting to generate profitable contributions.

Calgro M3 is currently viewed as a risky, home construction Group. But, I do believe, that the Group’s Memorial Parks and the REIT JV are likely to be built into material-sized businesses in the next five or so years. Hence, I believe in five to ten years time, far from being a risky counter, Calgro M3 will be viewed as a defensive funeral and residential play with a free property development option.

While the stock is currently trading on a 9.5x Price Earnings, what multiple would you think a defensive funeral and residential business would demand…?

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