Monadelphous: leader of the pack?
Sometimes it’s easy to identify the source of competitive advantage that drives the performance of a great business. For example, it may be intellectual property supported by large R&D investments in the case of companies like Resmed or Cochlear; it may be network effects and a dominant market position in the case of businesses like REA Group or Carsales; or it may be ownership of long life, very low cost resources for a mining company.
Sometimes, however, the source of competitive advantage is hard for outsiders to see. Sometimes it’s hard even for management to articulate why they are so successful. It may be due to business systems, processes and cultures that just “work” – a thousand small things that all fit together to make an efficient machine. And that’s fine. It’s difficult for competitors to replicate these sorts of advantages, and so this can give a company a continual edge.
Of course, when investing in this sort of business you do want to be comfortable that the underlying source of competitive advantage is real, and that it can be sustained. That brings us to Monadelphous Group Limited (MND), a leading provider of engineering and construction services to the resources and petrochemical sectors.
MND has an outstanding track record across a number of measures. Over many years it has maintained a phenomenal >50% ROE, and produced very strong free cash flows. Despite recent price weakness, shareholders who have been on the register for a decade or so have seen the share price increase by a factor of more than ten times, and have enjoyed healthy dividends along the way. MND has been an absolute gem.
So how has it done this? Well, MND just seems to be very good at what it does. It is the contractor you go to when you need to know work will be done on time and it will function, and you don’t mind paying to ensure these outcomes. MND has built an excellent reputation; one that has genuine value.
However, the market outlook for engineering contractors has changed materially in recent times, and with those changes it’s important to think about whether MND’s advantages will protect it and allow continued prosperity. This is potentially a big ask, as the company summarised in its FY13 results disclosure: “Revenue levels for FY14 expected to moderate after abnormal growth surge”.
We have some concerns around this point. MND may be a world-beating contractor, but it is still a contractor, and there are a host of issues that arise for this sort of business as a result of the decline in Australia’s resources capex boom. These include:
- Falling volumes of work. An obvious point, but the fall in industry-wide revenues for contractors may be marked, and there is nothing MND can do about it, no matter how capable its management is. Retailers may complain about weak spending growth, but contractors on the wrong end of a capex cycle really have something to lament about.
- Price competition. A lot of industry capacity was added during the mining boom, and that capacity would like to stay utilised. Price competition ensues as contractors all punt for a larger portion of the available work. Needless to say, market shares still need to add to 100% and the net result for the industry is lower revenue per unit of work, across an overall reduced volume of work.
No surprises so far, but what of MND’s competitive strengths – do they allow it to weather this storm in much better shape than others may be able to?
While there is no doubt that MND’s organisational competencies remain valuable, it may be that they become significantly less so in a tougher market. Clients, who were focused on getting projects completed quickly and reliably in boom times, may become far more cost conscious as their own businesses come under financial pressure. In these circumstances, discounted pricing on offer from lesser contractors may seem like a more compelling proposition than the assurance of having work done quickly and reliably. If this happens, the advantages that have served MND so well during the good times may quickly fade, and the company may move much closer to the pack.
While the recent pullback has brought the MND share price closer to value territory, it continues to command a large premium over less well-credentialed contractors. Even though MND is undoubtedly a class act amongst contractors, if its competitive strengths lose their power in a more challenging market, the current share price premium may be difficult to justify. Investors – as well as clients – may wish to consider cheaper alternatives.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
