Another angle on FGE plus tidbit on CMI

Clough Limited (CLO) is another mining services company listed on the ASX and exposed to the oil and gas sector. On 11 December 2012, CLO announced that it had renewed a $200m debt facility.  How is this relevant to FGE?

CLO is the biggest shareholder of FGE, holding roughly 36% of shares in FGE.  As at June 2012, CLO had $146m cash on its balance sheet. The last substantial shareholder notice published by FGE in May 2012 showed that CLO added a further 3% in compliance with the creep provisions of the Corporations Act. 

In 2012, CLO made $42m in profits and is currently trading at PE 15. FGE has $130m cash as at June 2012, and has had a good half with NPBT forecasted at $50m. If CLO takes $100m of its cash, combined with $130m of FGE cash, totalling $230m, it could afford to take over FGE for up to $360m. The current market cap for FGE is $335m. Alternatively, CLO could just use $200m from its debt facility to do the same thing, and after the takeover, repay the debt in full with FGE’s cash plus a bit of its own. With CLO’s huge blocking and controlling stake, a rival bidder is very unlikely.

An acquisition by CLO will be immediately and significantly PE accretive without any synergistic costs savings. In fact, CLO’s earnings would more than double, and its margins will increase by about 50% with FGE in its fold, and this can be done with minimal dilution.

All these are pretty obvious, so what am I missing?

My best guess from CLO’s perspective is that there is no hurry since CLO has a large blocking stake which renders the possibility of a rival bidder vanishingly small. CLO can take advantage of lower prices using the creep provisions. In the current environment for mining services, it is also prudent for CLO to preserve its cash rather than making any bold moves. CLO’s largest South African shareholder is probably loath to risk contributing more capital to CLO and prefers CLO to keep a clean healthy balance sheet.

A takeover by CLO has been long anticipated and speculated by the market, at much higher prices for FGE than the present.  These speculations have intensified with recent management changes at FGE, and the recent exercise of options by outgoing management at prices up to $5.60 perhaps indicate that they do not see any potential upside beyond $5.60 for FGE due to the potential for a takeover at prices below that.

It will be interesting days ahead for FGE.

Lastly, a little tidbit on CMI, with the newest director, Stephen Lonie, spending over $120,000 of his own money buying up 65000 shares in recent days.

Disclosure: The author owns shares in FGE and CMI.

Disclaimer: the content of this post is not to be relied on as financial advice.  It contains my personal opinion only, plus facts that I cannot verify to be accurate.  Do your own research and seek financial advice where appropriate. I have made many mistakes in the past, and will continue to do so in the future.

Forge Limited (FGE)

I recently tweeted that I am examining 3 shares which I believe are undervalued.

The third of these is Forge Limited (FGE), and I am forced to publish this earlier than expected as the company has jumped the gun on me (explanation below).

An extreme valuation sometimes makes purchase decisions very easy. The investor is given such a large margin of safety in relation to the purchase price such that not many things need to go right to get a decent return. On 5 December 2012, FGE provided this opportunity when it released an earnings update for FY13. 

FGE told the market that it expected to make Net Profit Before Tax of $90m to $100m for FY13. Give that 5 months of FY13 have already elapsed, and given that FGE stated that it expected the NPBT to be split evenly between two halves, at least $40m of NPBT has already been earned.

By way of background, FGE is an engineering and construction company providing mining services to the mining industry in Australia and Africa. As a group, mining services companies on the ASX have been deserted en masse by investors fearing the end of the commodities boom and a contraction in mining investments.

In the words of Jamie Mai, extracted from the book Hedge Fund Market Wizards by Jack Schwager, “markets tend to overdiscount the uncertainty related to identified risks.” Further, “although markets are generally good at estimating the magnitude of a contingent liability, they are often poor at evaluating outcomes probabilistically.”

It is my view that in the case of FGE, the market has overdiscounted both the rate and the magnitude of future earnings decline.

Valuation

FGE has 87 m shares on issue.  At AUD$3.85 cents, market cap is AUD$335m.  

Earnings

Earnings update on 5 December 2012- NPBT$100m. NPAT $70m. At least $40m of NPBT has already been made to date.  Backing out cash of $130m on the balance sheet (as at June 2012), this is effectively PE 3. An investor is paying about $210m for all future cashflows from FGE, bearing in mind that as at June 2012, FGE had an order book of $900m, and since June 2012, FGE has announced further contract wins totalling $360m.

A good part of FGE fortunes are tied to the actions of RIO, FMG and Roy Hill. These companies are racing against time to expand their iron ore output before iron ore prices decline further. 

Going through the financial statements, variable costs made up 60% of revenue in 2012, up from 46% in 2011. However, wage costs as a percentage of revenue have declined from 37% in 2011 to 27% in 2012.  This lower level of fixed costs provides a safety buffer in the event of a contraction in revenues.  At current prices, even if FGE's earnings declined by 50% (which is quite a distinct possibility), earnings multiple are still in the lowish single digits.

The market is pricing FGE as if it will experience an earnings decline to the vicinity of $20m per annum.  This is not impossible, but for what it is worth, I believe that the chances of this happening in the next 5 years is quite remote. The more likely scenario is that within the next 5 years, total free cashflow from FGE will exceed the share price being paid today.

Disclosure: The author owns shares in FGE.

Disclaimer: the content of this post is not to be relied on as financial advice.  It contains my personal opinion only, plus facts that I cannot verify to be accurate.  Do your own research and seek financial advice where appropriate. I have made many mistakes in the past, and will continue to do so in the future.

Coffey International Limited

I recently tweeted that I am examining 3 shares which I believe are undervalued.

The second of these is Coffey International Limited (COF).

COF is an engineering consultancy company with a history going back to 1959. It listed on the ASX in 1990. The company went on a diworsefication spree from 2003 to 2008, acquiring more than 30 businesses from a combination of cashflow, capital raisings and debt, until the GFC stopped this stupidity. Faced with heavy losses from write-offs, coupled with heavy staff turnover, management changed hands in March 2011. Since then, current management has restructured the business by selling and discontinuing non profitable businesses, cutting down debt, and improving operational efficiencies. 

In a nutshell, the core businesses of COF are quite stable.  This arises from its entrenched relationships, embedded expertise and geographical reach, aided by a very fragmented customer base. Not unlike the story of GEICO, management is engaging in cancer surgery, stripping away the useless parts and retaining the good businesses at its core.  Management’s efforts are starting to gain traction- costs are coming down, margins are being maintained or improved, staff turnover is reduced.

Due to disappointing results in the last few years, and an anticipated slowdown in mining investments, I believe that the market is now overdiscounting near term uncertainties for COF, and overlooking the underlying trend improvements in COF’s businesses.

Valuation

COF has 256 m shares on issue.  At AUD$0.32 cents, market cap is AUD$82m.   Operating cashflow is AUD$21m per annum, giving P/Cashflow multiple of 4.  If I add $66m of net debt, the enterprise value/ cashflow multiple is 7. Given COF’s long operating history and stability of its revenues, a reasonable valuation is about 10 times multiple.  Hence current market price is a 30% discount, assuming no costs improvements and no revenue or margin growth.  Recent update by management on 4 December 2012 appears to indicate that revenues are holding whilst costs are still being removed, although the outlook for the second half is still uncertain.

Earnings

Trailing PE is 11 based on NPAT of $7m derived by adding back $37m worth of write-offs.  At this stage, due to write-offs and restructuring, earnings multiple is not a reliable indicator of the value for COF.  In the long run, we expect the earnings to match the cashflow, which will bring earnings multiple into the low single digit figures. 

Balance Sheet

As at June 2012, COF has net debt of $66m.  There are $9m in franking credits.  

Disclosure: The author owns shares in COF.

Disclaimer: the content of this post is not to be relied on as financial advice.  It contains my personal opinion only, plus facts that I cannot verify to be accurate.  Do your own research and seek financial advice where appropriate. I have made many mistakes in the past, and will continue to do so in the future.

CMI Limited

I recently tweeted that I am examining 3 shares which I believe are undervalued.

The first of these is CMI Limited.

CMI operates two divisions, Electricals and TJM. 

Electricals revenue for FY 12 is $74m, returning EBIT of $21.5m.  TJM revenue for FY 12 is $40m, but EBIT is only $1m.

Electricals are facing headwinds due to declining coal sector investments in Qld, and also subdued industrial and housing activity.  

TJM has a lot of room to improve when performance is compared with ECB and ARP.  TJM is an established high quality brand with steady revenue, however the division is saddled with high costs due to the number of distribution centres, and management appears to be trying to contain costs by moving manufacturing to China.  ECB and ARP both generated EBIT margins in the mid teens, and if TJM can do just 10% EBIT, the EBIT from this division will go up 4x. I suspect that the TJM division is being dressed up for an eventual sale, and logical acquirers are AMA and ARP.

The problem with CMI has been management’s treatment of minorities over the last several years, culminating in litigation brought by Troy Harry last FY. With the death of long time owner Catalan, and succession to his daughter Leanne Catalan, the situation with management is still less than optimal, especially as management owns a controlling stake.  We suspect management’s actions account for the perennial share price underperformance, made worse by the previous unwieldy structure of having two classes of shares.  The structure has since been rationalised this FY following litigation brought by minority shareholders.  There is still some overhang of a big parcel of shares bought by Leanne allegedly in contravention of the provisions of the Corporations Act which was the subject of litigation at the Takeover Panel.  This matter is still subject to appeal, although I believe this is unlikely to matter in the big scheme of things.

Valuation

CMI has 38.2m shares on issue.  At AUD$1.70 cents, market cap is AUD$58m.   Operating cashflow is AUD$9.5m, giving P/Cashflow multiple of 6, and the multiple is slightly less than 7 if we include debt of about $8m.  Normalised EBIT is about $20m. A very conservative 5x EBIT puts CMI at AUD$100m. Current AUD$58 implies a 42% discount to a very conservative valuation. Even if EBIT drops by half to $10m, the EBIT multiple of 6 is still within conservative territory.

Earnings

Trailing PE (normalised without write-off based on NPAT of $14m) is 4.   Outlook given on 30 November 2012 appears to indicate that Electricals is holding and TJM is improving.  Market cap of AUD$58m allows an earnings deterioration by 50% to $7m,  and even then, the PE is still a lowly 8.  This provides a degree of margin of safety

Balance Sheet

As at June 2012, CMI has $8m in bank debt.  This is more than covered by operating cashflow of $9m. There are $16m in franking credits. There is also an impairment provision for a third party loan of $17m which has been written off to zero, but which I am confident will result in some recovery. There is a personal guarantee for $2.5m for this loan which CMI is now pursuing.  Working capital is about $37m which is about 1/3 of sales, and I expect there is some room for improvement here to boost the balance sheet.

Disclosure: The author owns shares in CMI.

Disclaimer: the content of this post is not to be relied on as financial advice.  It contains my personal opinion only, plus facts that I cannot verify to be accurate.  Do your own research and seek financial advice where appropriate. I have made many mistakes in the past, and will continue to do so in the future.