Cash versus profits at Armorgroup (ARG)

Plenty of one, not enough of the other

I own shares in Armorgroup, supplier of mercenary guards to governments and corporations in charming locales such as Nigeria, Afghanistan and Iraq.

The basic reason for this is fairly simple: ARG makes money, yields 4.8 per cent and trades at its tangible book value. There are very few such shares on the London market.

The trouble with Armorgroup is low profitability. Look at the table below:

	2006	2005	2004	2003	2002
Sales	273,453	233,150	190,190	98,187	79,593
Operating profit	10,607	12,405	17,048	3,682	(8,154)

 

The first half of 2007 was even worse, with operating profit down to $3.5m, but there are a couple of observations to make:

• Profitability was clearly managed to an unsustainable peak in 2004 - the year of the IPO. Private equity always does this. I’m embarrassed for the people who buy companies from them.
• Since 2004 sales are up 44 per cent while operating profit is down 38 per cent. What’s going on?

A few things. One is that management has gone on an empire-building rampage, opening offices all over the world. Overheads went from $34m in 2004 to $49m in 2006. Another reason is increased competition in Iraq and Afghanistan that has hurt margins.

But look at this:

($’000)	2006	2005	2004
Operating profit	10,607	12,405	17,048
Cash inflow from operations	30,650	15,811	11,900
Depreciation	14,871	10,654	9,018
Loss on disposal of fixed assets	1,141	455	169

Cashflow from operations is going up even as operating profit goes down. The reason is that Armorgroup is having to invest in buildings and vehicles to support all the new contracts it has won, which means higher depreciation, and lower profit.

The question is whether profitability will rise as those contracts mature and there is some cause for hope. Armorgroup depreciates its armoured vehicles in Iraq on a ‘non-linear basis’, which I take to mean that it takes a big charge in year one and less in year two, while still using the asset. As contracts get older, they should get more profitable.

The ARG share price may take a couple of years to turn around: the expansionist management are now talking about acquisitions, which always gives me a slightly sick feeling.

There are plenty of other risks too, from deeper chaos in Iraq, to tougher competition, to loss of reputation in the US following the Blackwater scandal.

But I think the shares are cheap and, by 2009, I think profits will be substantially higher.

Disclosure: I own shares in Armorgroup.

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