March 26, 2012
PORTFOLIO POINT: Coal mining services provider Mastermyne is attractive if you consider its work in hand, revenue and earnings prospects. Cash flow, however, must be watched closely and value has recently taken flight.
Investors can be an irrational lot. When share prices are low, investors are reluctant to buy, preferring first a rise in prices to confirm their beliefs. Yet when those beliefs are confirmed and after share prices rise, the reluctance to buy remains; now the investor waits for lower prices to provide a more attractive entry point.
Mastermyne (ASX:MYE) has enjoyed a recent surge in its share price. Even though the rise has pushed its share price above a rational estimate of intrinsic value, it should not dissuade an investigation of MYE as conventional wisdom suggests favourable industry dynamics bode well for its earnings prospects over FY2012 and beyond. For now, turn the stockmarket off and focus on the business.
Mastermyne, established in 1996, is Queensland’s “leading” provider of specialist underground coal mining services. The company’s operations are primarily in the Bowen Basin, but the company also enjoys a growing presence in NSW’s Illawara. The company counts BHP, Rio, Vale and Anglo Coal among its Tier 1 customers. Demand for the company’s services is tied to coal production volumes and the short and medium-term outlook for coal production is positive, thanks to demand from emerging economies.
Bright prospects do assume the following: a benign environment for union action against coal miners (union action is currently underway for the BHP-Mitsubishi JV); no impact from litigation by the “Stopping the Coal Export Boom” movement that has also carefully planned and funded litigation action to delay development of port and rail infrastructure; and the spread of new production in Queensland’s Galilee Basin and NSW’s Hunter Valley.
Mastermyne’s three business segments are:
Mastermyne Underground (Mining Services) (>90% group revenue) (underground conveyor installation, extension and maintenance; underground roadway development; underground ventilation device installation).
Electrical and Mechanical Services (>1% of group revenue) (above ground electrical and mechanical services, including construction, maintenance and overhaul of draglines, wash plants, materials handling systems and other surface infrastructure).
Engineering and Fabrication (designs and fabricates attachments for underground equipment; general engineering and fabrication; supply of consumables for underground coal mines).
Since listing in May 2010 and under the direction of Tony Caruso (CEO since 2005, MD since 2008 – pictured above at far left during Mackay’s best business 2010 gala awards), MYE is off to a good start as a listed company. Importantly, investors should note that of the $40 million raised in the float, not a dollar went into the business. About $2.3 million went to the deal’s brokers and vendors received $37.7 million. Equally importantly, the company didn’t say in its prospectus that the proceeds had been used as ‘working capital’. I have seen plenty of companies that did, even though not a cent went in.
Supported by a strong order book, MYE exceeded its prospectus forecast revenue and earnings for 2010 by circa 4%, and earnings for 2011 by 10%.
Citing limited ‘through-the-cycle’ performance transparency, many investors get nervous about a company that is either new or newly listed. There is no escaping the argument in this case. Not only that, but the fact remains these types of mining contractors typically have high operating leverage and feast can quickly turn to famine, especially where barriers to entry are low (such as in this case) and competitors are willing to price irrationally when pickings get slim. However, between FY2007 and FY2010, MYE achieved compound annualised growth of 17% in earnings before interest, tax and amortisation. Encouragingly, the company grew operating earnings during the GFC and, in a more recent six-month period to August last year, grew its FY2012 contracted order book by 30% – this on top of the previously mentioned prospectus-exceeding growth for FY2011 and second-half 2011 operating earnings growth of 22%.
During MYE’s annual general meeting (AGM) late last year, a very strong start to the current financial year was also cited. Growth in the two smaller divisions is being targeted (expect strong growth off a low base) and the company is positioning to engage in larger projects that are coming online over the next three to four years. Specifically, Mastermyne said that demand for its services remains strong and is increasing.
While several analysts have cited MYE’s strong employee growth as evidence of its statements about pipeline growth, it also serves as a reminder of the operating leverage that engineering contractors typically display. A leading position is essential in the event that industry-wide revenue ever turns south.
Watch the cash
On a work-in-hand, revenue and earnings basis, this is a company with bright prospects. The one caveat, however, is cash flow. Ultimately, it is by cash flow that a company lives and dies. A company waiting for its customers to pay while growing fast must manage its cash flow very carefully.
As is typical in a capital-intensive business (note: reason to moderate any plans for grand portfolio allocations), growth requires significant capital expenditure, as well as more typical variable expense increases. For 2011, net operating cash flows declined from $15.1 million to $9.4 million (take a look at the $20 million jump in receivables for a partial explanation). However, after subtracting $2.6 million for capex, the company was still able to pay its borrowings down by $6.7 million (the apparent increase in ‘borrowings’ is due to finance leases – another cost associated with expansion). Finally, a dividend of $2.6 million arguably caused the bank balance to decline by $2.2 million in 2011.
Using my method to estimate business cash flow, an $8.7 million business cash outflow can be offset by an $11 million increase in property plant and equipment, but the company really needs some of those 1200 additional staff it has taken on to be working in the receivables management part of the back office.
I suspected the accrual accounting used to record revenue would be based on effort expended, and indeed, the annual report confirms this:
“Revenue from services rendered is recognised in profit or loss in proportion to the stage of completion of the transaction at the reporting date…”
However, clients like BHP, Rio, Anglo Coal and Vale, while making a great looking CV, will also ensure Mastermyne won’t be dictating cash payment terms. The impact of this should not be underestimated, because Mastermyne will require cash to maintain and expand its equipment fleet, as well as maintain dividends (forecasts for per share dividends can be seen in the graph below).
Only once you are comfortable with an understanding of how the cash flows through the company, its quality and its prospects do you move to analysing its intrinsic value.
Intrinsic value is a function of a company’s equity and the profitability of that equity, as well as a conservative required return.
The make-up of Mastermyne’s equity is therefore important and an examination of the balance sheet reveals that a not-insubstantial portion of the owner’s equity is comprised of intangibles, namely goodwill. The payment to the vendors of around $40 million was well in excess of the book value of net tangible assets, and so the accountants created a common control reserve to ensure the balance sheet balanced. The upshot is this would be a problem if the company were required to borrow meaningful funding. The combination of operating leverage and higher debt (if it were to grow) is itself less than perfect, and debt backed by goodwill leaves shareholders with precious little to support share prices if revenue or operating margins were to turn down.
That appears unlikely in the near term and so we move to the other element of the intrinsic value equation, which is return on equity. For the next two to three years, these returns are expected to remain high and stable at around 31%.
Based on these expectations, and turning the stockmarket back on, Mastermyne is trading at a premium to its current value. A pullback to $1.80, if it were to transpire and all else being equal, should be a trigger to pull the file out and conduct some due diligence on the company’s prospects at that time.
*Mastermyne (ASX:MYE, Score B1) is a small Montgomery [Private] Fund holding.
by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Manufacturing, Skaffold
February 10, 2012
Following on from our comment yesterday about BHP and comments in the media explaining why we weren’t buyers of BHP or RIO (falling Iron Ore prices and a contracted customer (28% of RIO’s revenue last year) who won’t honor contracts), we are interested in the flow of information through the week.
First the RBA held off cutting rates. Did they know that China would soon be exporting inflation (cost pressures there)? Then the next day China reported…guess what….the biggest jump in inflation…so forget about rate cuts there to help out US and Euro exports?
And now we are hearing that over at RIO a freeze has been placed on contractors and recruitment. Read; “massive overspend / cost inflation”.
Today Bloomberg quoted an analyst on China: “Domestic demand was genuinely weak in January, while exports remained on a gradual downward trend,” said Yao Wei, a Hong Kong-based economist for Societe Generale SA. And “Tom Albanese, chief executive officer of Rio Tinto Group, said yesterday he remains confident of a so-called soft landing in China… Inflation (CNCPIYOY) accelerated last month for the first time since July as food prices climbed before the holiday that started Jan. 22, a statistics bureau report showed yesterday. An index of export orders in the agency’s survey of manufacturing purchasing managers released last week showed a contraction for the fourth straight month. The IMF said in a Feb. 6 report that China’s economic expansion may be cut almost in half from its 8.2 percent estimate this year if Europe’s debt crisis worsens, a scenario that would warrant “significant” fiscal stimulus from the government.(See my postscript).
17/2/2012 PostScript: An analyst we regard highly wrote this to us today:“On this recent visit, our wise counselor forecast China’s growth rate will be in therange of 8 to 9% in 2012—assuming no major external shocks. Inflationary pressurewill be lower this year than last, especially in the first half of the year. The inflation ratein China for the entire year will be lower than 4%. Low inflation will allow thegovernment to deregulate prices—water, natural gas, and power.Our trusted counselor believes that export markets cannot be counted on to deliver thegrowth that China needs in 2012. Likewise, domestic consumption, while on the rise as apercentage of GDP, is hard to stimulate quickly. Therefore, the only remaining option to preventChinese economic growth from slowing is for the government to use investment as a stimulus.”
“On this recent visit, our wise counselor forecast China’s growth rate will be in therange of 8 to 9% in 2012—assuming no major external shocks. Inflationary pressurewill be lower this year than last, especially in the first half of the year. The inflation ratein China for the entire year will be lower than 4%. Low inflation will allow thegovernment to deregulate prices—water, natural gas, and power.Our trusted counselor believes that export markets cannot be counted on to deliver thegrowth that China needs in 2012. Likewise, domestic consumption, while on the rise as apercentage of GDP, is hard to stimulate quickly. Therefore, the only remaining option to preventChinese economic growth from slowing is for the government to use investment as a stimulus.”
Here’s a quick view from Skaffold of RIO. To become a Skaffold member and enjoy having every stock in the Australian market quality rated and valued and all valuations and data automatically updated for every company every day CLICK HERE
by Roger Montgomery Posted in Energy / Resources, Insightful Insights, Manufacturing
October 13, 2011
With high salaries, higher rents, a strong Aussie dollar and ‘level-playing-field’ policies, are Australian manufacturers being unwillingly and inexorably dragged to doormat status?
We are in a race to the bottom and run the risk of ultimately being chewed up and spat out when our commodities are no longer required with such urgency.
Driven by a belief that economists are right and the way to measure happiness is by the consumption of “stuff”, government policy in Australia is set to keep the masses happy by making that “stuff” as cheap as possible.
Our way of life, and the quality of that life for our kids, is at risk if we continue to be apathetic. Driving around Sydney’s Eastern Suburbs and Lower North Shore, its apparent there isn’t a communal approach to the solution. Instead there is an individual race to accumulate more “stuff” to protect oneself. “Forget about the neighbours”. “Look after number one”. “If I have plenty in the bank, the kids and grandkids will be set up. What do I care if the rest of Australia goes to pot?”
It’s like watching seagulls fighting over a Twistie.
When competing against a country with an ethos that puts ‘the people’ first, what hope does a country whose constituents are clambering over each other for the next short-term dollar have?
Manufacturing in Australia needs help. I am not suggesting protection or a hand out. I am suggesting a leg-up.
Singapore rolls out the red carpet for new businesses with tax-free holidays for the first few hundred thousand in profits. What does the Australian government do for new businesses in Australia? A TAFE course? R&D tax breaks are a start, but helping big business roll out classrooms at $5000 per square metre helped who exactly?
Unemployment in Australia’s wealthiest suburbs is creeping up because we don’t need so many bankers and Merger & Acquisition experts when there aren’t any businesses left to merge and acquire.
Can our current way of life survive without manufacturing? It seems we may just find out. What will we do without manufacturing?
The commodity boom will end one day and we are selling large tracts of arable land to foreign investors. Without manufacturing, will we be running around serving each other lattes? Is that it?
Australia is still the home of ingenuity. Just look at programs like the ABC’s New Inventors. The best and brightest should be receiving generous awards and access to incubator programs that ensure the international success and that the commercial benefits flow back to Australia.
One American recently lamented “10 years ago we had Steve Jobs, Bob Hope and Johnny Cash. Now we have no jobs, no hope and no cash”. If we don’t want to end up in the same place, Australia needs to do more to help incubate, nurture, commercialise and protect our best ideas.
And what are we doing bringing the brightest foreign students into Australia, giving them some of the world’s best education and sharing our IP and then, when they graduate, telling them they cannot work here and sending them home to compete with us?
“Go Australia”? Or “Go, Get Out of Australia”?
We also have some amazing established manufacturing businesses – paint, water heaters, bull bars, truck tippers, caravans, mattresses, wine, beer, pharmaceuticals, chemicals, anoraks, toilets.
The list of those producing attractive products and results is nothing short of A1.
A company that…
1) Has built a brand and or reputation for quality, value or innovation;
2) Is vertically integrated – owning the distribution channel;
3) Is manufacturing a highly specialised or customised product and not competing solely on price;
…has a chance to succeed in manufacturing in Australia. And while it’s a shame our government has gradually allowed manufacturing to ‘die’, there are pockets within which Value.able Gradutes can find extraordinary businesses, especially when the market’s manic phase turns to depression.
Many of the manufacturers listed in the following table have a long history of operating through a variety of economic conditions. They are ranked from A1 down to C5 – you can immediately see the broad spread of quality. I find looking at the ‘tails’ to be particularly insightful.
While declining in volume, manufacturing in Australia is not dead. Indeed some businesses are positively ‘raking it in’.
Manufacturing is tough and because inflation is always running against a business with a high proportion of fixed assets, smart managerial decisions are constantly required.
Ironically, with so many winds against manufacturers, those that have little or no debt, high rates of return on equity, bright prospects for future growth in intrinsic value and are trading at substantial discounts to current intrinsic value, may just prove to be Value.ablely positioned to leverage a broader economic recovery, locally and globally.
Who’s your top pick for Australia’s best manufacturer? I also want to hear your stories about manufacturing here. Are you a business owner that makes something we should be proud of? How is government policy or a monopoly customer affecting you? What changes need to be made to give Australia a fighting chance?
The universe of great businesses to invest in will inevitably decline unless something is done.
I look forward to your stories. They will be read by the who’s who in banking, management and government, so jot down your thoughts and share your Value.able experiences.
by Roger Montgomery Posted in Insightful Insights, Manufacturing, Value.able