Tuesday, June 4, 2013

Confession Box 5 June 2013

On 4 June 2013, I sold my FGE holdings for $4.48.

This came in the aftermath of FGE's announcement of an acquisition. Despite massive cash holdings and a weakening AUD, management decided to fund the acquisition through a mixture of debt and equity.

My rationale for purchase of FGE was first set out here, and also in a subsequent post here.  Events subsequent to my purchase have eroded my margin of safety in this investment.  Nevertheless, I wish to make it clear that the purchase was an error on my part as it was based on inadequate due diligence.  If I had done some better due diligence, the events subsequent could have been mostly foreseen.

The half yearly results in February 2013 clearly disclosed severe margin crimp, given that revenues increased 120% yet NPAT only increased by 60%, with NPAT margins in single digits. This arose as a direct result of increasing reliance on low margin work from the power division.  Subsequent contract awards in this space only heightened the risks involved.  My attitude to this was blase to say the least.

Then Clough decided to sell all its shares in FGE, which further weakened the investment thesis. However, since the probability of a takeover at higher prices was a free option in my investment thesis, I brushed off this event without further investigation.

The unusual nature of the Taggart acquisition prompted me to do a much belated due diligence on the management team, particularly David Simpson, the MD.  One of my Google searches turned up several articles on the appointment of David Simpson on a very lucrative pay package, which was acknowledged by the FGE board (then) as being on the high side.  The sad thing is that all of these articles predate my purchase, and I did not read a single one at any time prior or at the time of purchase.

In a nutshell, Simpson was paid $750k to sign on, with a yearly salary of $1,000,000, together with short term incentives of 2 tranches of $500,000 payable on achievement of an increase of 10% EPS from one period to another.  This is such a ridiculously low hurdle for such a huge payoff, it amounts to a joke.

Briefly, David Simpson's bio:

Diploma of Law, Masters of Law and Management.  Progression through lawyering as corporate counsel in three previous companies. Started career as a paralegal in ABB in early 1990s, then corporate counsel in Leighton, and then moved to UGL as corporate counsel, then as manager of one of UGL's divisions, before taking on the post of MD in FGE.

In other words, you have a corporate lawyer with very little technical/engineering background leading an engineering company, with a $1 million dollar short term bonus dangling in front of him.  All he needs to do is increase diluted EPS by 10%. Upon his appointment, the old guard at FGE left and promptly sold all their shares in the mid $5s.

Once I saw this, everything fell into place:

1. The Taggart acquisition was structured with an upfront cash payment, funded by debt. Subsequent milestones payments are paid via 70/30 mixture of cash and shares. The upfront cash payment goes straight to the balance sheet, and does not affect earnings, but the target acquisition earnings are accretive immediately. Subsequent dilutive milestone payments in shares do not affect the MD's short term bonus.

2. Continual contract awards in the low margin power divisions.  Margins are being sacrificed for the sake of volumes, which is very dangerous in any business other than mature businesses with incumbent management with demonstrated experience in a low margin high volume environment. 

Given this trend, I see a distinct possibility of continual erosion of my margin of safety in this investment, with gearing up of the balance sheet and increasingly high capital requirements to maintain low margin businesses in the power area and underground coal mining, coupled with integration risks of Taggart, together with some massive headwinds hitting the mining services sector. Plus a huge risk with a corporate boardroom MD granted questionable incentives.  

Taken to extreme, increasing debt and low margins are recipes for very sudden implosion, which brings us back to Rule Number 1.

This investment yielded 19% returns over a 6 month period, which was again just down to pure dumb luck.  My penance was an immediate indepth management review of all portfolio holdings.

1 comment:

Eternal Growth Partners said...

Cracking analysis Peter, we all get lucky from time to time. I would hazard you're probably being modest in how lucky you were, plenty would not have made the second effort that led to your 'luck' - Tony