I sold my Pennant International holding. For it to be my biggest position, it has to
be my best idea, and it simply wasn’t.
Being a contract based business, there are no recurring revenues to
speak of, and the variety of different contracts it has won does not suggest
any sort of competitive advantage. I
realised I have no real visibility on when contracts end and am unable to
predict what profits might be over the next few years. It’s economically sensitive as well, which we
saw in the period after the crisis, when it was making losses. Finally, while returns on capital have been
outstanding and are one of the things that attracted me to the company, these
returns will attract competition at some point.
Given that I don’t believe there’s much of a moat apart from
relationships, perhaps, I think it’s best to take the 25% gain that I’ve had
over the last 6 months or so, and move on to a higher conviction investment.
After a
great deal of procrastination, I’ve decided to invest the cash in Emeco Holdings:
Market Cap
(A$): 160mln EV: 508mln P/tB: 0.37 fEV/EBITDA: 5.8
fEV/FCF: 3.4 Price: 0.265
It’s an Australian company that provides
rental equipment to miners. The industry
often requires “swing capacity” – the ability to access additional equipment
without purchasing it, and so they fulfil a key role. This demand might be during exceptionally
busy periods when the miner’s own equipment is at maximum capacity. Alternatively, it might be when the mine is
towards the end of its life and the miner is reluctant to invest in brand new
equipment that might only be required for a short period of time.
What’s the story?
It’s fairly
typical. Overinvestment at the top of
the mining cycle has led to the company owning too many assets and having too
much debt at a time when there is a glut of mining equipment in the industry
and not too much excess demand for Emeco to fulfil. Revenues have plunged, leading to the company
being forced to deleverage. The stock trades
near its low of 0.17, from a high of 1.21 in 2011. Equipment utilisation is down below 50%, from
an average above 80%. That’s a lot of
expensive mining equipment lying idle.
Value Investor Boxes that it ticks:
The company
has operated since the early ‘70s and operates in an industry that is not going
anywhere.
Downside
protection as it’s trading at a discount to liquidation value – 37% of tangible
book.
Small cap
name in a non-mainstream market (Australia).
General
investor hatred of the industry and general fear of economic downturn in China.
Depressed
industry.
Cheap versus
book value – “disguised net/net”.
Private
Equity interest in the recent past.
However, the
business model is not great. It requires
use of debt in the capital structure to generate the required returns on
equity, but it operates in an incredibly cyclical space. Mining itself is unpredictable, and the fact
that Emeco is used to provide extra capacity gives it cyclicality on
cyclicality. During downturns, the first
equipment that a miner will stop using is the stuff it has rented. So in a steady state, it should trade at book
value perhaps, though I wouldn’t own it.
The market currently hates this stock because it’s posting
losses and has a LOT of debt. The recent
management call revealed they were selling equipment at 25-30% below book
value. When the company is 45%
leveraged, that implies the value of the equity is 50% of book. Crucially, they have refinanced in the friendly
US high yield market and now pay 10% on 340mln on debt. Not widely known, they have a call at 101 in
three years time. This gives the company
breathing space to do nothing, and wait for the glut of mining equipment that
is out there to burn off. Emeco
depreciates its assets over seven years, and the average life when fully utilised
in 5-10 years. FCF is positive at 70
this half alone. This means that if the
industry as a whole buys no new equipment (and why would it, with plenty of
second hand stock out there), a substantial proportion of the total capital
stock will be used up in the three year time frame, including Emecos. So the company now has the flexibility if it
doesn’t like current prices to do a variety of things:
-
Do nothing and wait for better prices before
selling equipment.
-
Do nothing.
Inventory will deplete naturally over time if there is no new
investment.
-
Shift equipment between markets. Emeco is experiencing the biggest slump in
Indonesia and Australia. Canada and
Chile are slightly better.
-
Hope that demand recovers. Annualised revenue is nearly half of what is “normal”. Currently it’s about 60% of the 2010 low. One has to suspect that revenues move up in
the future.
So what happens from here?
-
Revenues move to something “normalised” – based
on the last 8 years – something like $463mln.
At historic revenues to asset levels, and historic debt/equity, the
company has roughly the right amount of debt.
I see normalised EV/EBIT of 7.1 and P/E of 3.9. Cheap.
-
The collapse in the Chinese economy that some
are predicting occurs. The mining
industry downturn spirals and Emeco has to adjust to a permanently lower level
of revenues and asset base. Let’s say
the current annualised revenue number of 253 is the “new normal”. This implies GFA of 394, and debt of 184, with
the company having 3 years to get there.
They would have to sell or deplete roughly half their asset base – cash coming
in of maybe 325. 164 would go towards
debt pay down, with around 208 to go to equity – more than the market cap! Obviously this is somewhat rosy and assumes
liquidation at book value, but there’s plenty to play with. New normal EV/EBIT is 3.5.
With this investment, you win either way. You’re just betting that management don’t do
anything stupid. The company has a
policy of paying out 40-60% of profits, so once it has restructured, I don’t
think there’s too much risk of anything value destroying happening.
At this point, I should own up to the fact that this isn’t
my idea. It’s been written up
extensively on various blogs:
Three of my favourites points made in the various write ups
are:
1)
If you think of the large portfolio of tens or
hundreds of items of various pieces of mining equipment as current assets, then
the business is a net/net.
2)
While the mining industry is currently
depressed, new mining equipment is still being sold. Caterpillar reported Q1 ’14 sales down 50% in
Asia Pacific. But they still sold
$464mln in the worst quarter in a decade, possibly. Given that mining equipment generally has a
5-10 year useful life, and excess capacity will be worked out over time, it
does not seem terrible if Emeco has to work out a few hundred million $s worth
of inventory over a few years. It
doesn’t have to sell, of course. It can
also just neglect to replace that equipment which has come to the end of its
useful life.
3)
Cyclicality swings both ways. The company has been able to completely turn
off growth and sustaining CAPEX, while inventory adjusts. This means that reported PnL vastly
understates cash flow, which will probably be around $50mln this year, versus a
market cap of $160mln. Given that the
company has a $300mln debt event in 3 years time, this is helpful.
So I’m buying this stock on the basis that it
has a combination of cash flow and asset realisation that is substantial when
compared to the EV. The company’s main
threats are known – a continuing downturn in revenues probably stemming from a
Chinese construction collapse. But this
threat is at a known time, and the CEOs one priority, really, is to ensure that
debt can be repaid and refinanced.
Mitigation is provided by the fact that is has diversity of
revenues. Canada’s oil sands now provide
a decent proportion of them and Chile is growing. And the company is diversified across
commodities as well.
