EHL.AX - Emeco Holdings

[yadayada]

Good points, but what i dont like about sedgman is that they have added risk of coal miners taking it inhouse (that is their only moneymaker now). Plus your heavily exposed to just coal. And there seems to be less upside then emeco.

 

Does Swick mining have any kind of moat? And again there you have exposure to more a more specific industry. Any reason to prefer drillbit industry above a leading lease player in the industry? I find leasing large truck more easy to understand :) .

 

I guess that leaves MacMahon and Emeco then?

 

Also how did you see they dilluted shareholders in 2002? I though tthey were taken public in 2006 or something? And they were much much smaller then they are now. Right now they have like 60% market share in Australia for example. Difficult to enter for other players now.

 

But I have the feeling that there is less variance with Emeco, because capacity just has to go up. I find it difficult to gauge how many new mines there will be built in the future. Emeco can profit if only current mines have increased output.

 

 

 

 

[writser]

I think you're looking at Emeco in the wrong way (or at least another way than me). The question is not whether they will do good if the mining sector booms again - surely they will. The question is if they can survive until then.

[xxx1313]

I think they will survive. The question I am asking myself is, whether the margin of safety is large enough. Asset disposals are made at about 20 % discounts to book-value recently. Together with relatively high financial leverage this over time reduces the value left for shareholders. They are cash-flow positive, but the net income also reduces book value.

[yadayada]

yeah but that is the downside case here isnt it? Since they are trading around liquidation value. detract intangibles and they need to sell equipment for bigger discounts then they do now as long as some cash flow keeps trickling in to lose as a shareholder.

 

Any idea if there is a time limit with current debt? Like what happens if they make a bit less then they did in 2013 in 3 years from now? 5 years from now? 2 years from now?

 

Will there be equity offering? Or will they just start liquidating? Latter doesnt seem that likely since insiders are probably more motivated to keep it going because of their scale advantage.

 

My point was, if Zinc and Iron pick up for example, you dont make any money on the other picks. And this one seems to be easier to understand.

[xxx1313]

Agreed with most of your statements, but:

"My point was, if Zinc and Iron pick up for example, you dont make any money on the other picks."

 

Why not? All plays in this beaten down sector have under utilized assets and would profit. MacMahon trades with at least the same discount to book as Emeco (p/b 0.3), does not lose money and has lower financial leverage, so they do not have to sell their mining equipment at steep discounts. Therefore, I as myself if risk/reward might be better there. If it only trades at book value, it is a threebagger. Less than two years ago, Mr. Market thought it was worth more than 2x book value. More or less the same is true for Emeco, I realize that. I see more risk with Emeco than with Macmahon that book value continues to decrease over the next quarters or years, so the gap could close not only by share price appreciation, but at least partly also by future losses.

 

So looking ahead 3-5 years you will probably make some money with Emeco, too.

[yadayada]

Macmahon is trading at 3-4x peak earnings? They seem to have pretty bad return on capital and are generating a lot less in cash. Also since 2006 they generated a bit more then their market cap in earnings and they seem to be hit harder by a downturn in mining? Emeco has next to newbuilds in mines, also exposure to regular mines having higher utlization, and the shale gas boom.

 

 

regarding assets, if you give a 30% haircut to their assets then it only trades at a 50% discount. How well do they age? They are not very specific. What do they have to spend in capex when shit hits the fan? If they go in cash harvest mode, how much FCF can they generate?

 

Also if shit really hits the fan for Emeco, can they just go in cash harvest mode and not buy new equipment for a while? Net cash from operations was like 181 million vs Macmahon's 108 million. It seems they dont want to do that just yet because now they can buy equipment more cheaply.

[ukvalueinvestment]

As I understand it, Macmahon's business model is contract mining, and is under pressure.  So, setting aside current low demand, you might not want to own this business forever.

 

Emeco seems to be more of a case of a business that will always need to exist, it just needs to rightsize without destroying too much value or suffering a liquidity/debt event.  Raising $40mln implies they sold their inventory at half price, I think.  Far from idea, when your 45% leveraged - it means roughly 75% of book value is destroyed - and I bought at 0.36 of tangible book.  I have to comfort myself with the fact that the Indonesia business was always likely to be shut down and there should be no more forced selling of inventory (and they've shaved 3.5mln off operating costs).

 

The reduction in EBITDA guidance?  Don't really care.  The earnings in three years are what interests me - when they have first call on their debt at 101 of face.  The reduction seems to be for plausible reasons.

[xxx1313]

Both businesses are mediocre, in my opinion. Both are under pressure. With long-term trends towards outsourcing in many industries, I also do not think that contract mining will disappear. Macnahon was moderately profitable even before the Australian mining boom of the last 10 years. With EV/EBITDA of about 1.5 (ok, more are less at peak earnings) not much has to go right for this idea to play out. In the worst case (liquidation) Macmahon's advantage vs. Emeco is the longer duration of their contracts. Their gradual expiration gives them more time to dispose their assets, probably close to book value.

 

I am glad about your confidence regarding Emeco though, because I own small positions in both companies.

 

[yadayada]

I don't think Emeco's business is really mediocre. It is cyclical, but they have a decent moat in australia at least. You need to be very large to compete with them, and there are safety concerns. There is not room for another large player now. Getting into this industry requires you to invest very large amounts of money, and then undercutting prices a lot, to get people to switch, because there is some stickiness. So you will be bleeding money for a while, and then after you get market share you only make v small returns because there are now two large players heavily competing on price.

 

I think it is a combination of a small spread with large capital requirements (because you need scale), and some need for a good reputation of safety and good maintenance that make it unattractive for new players to enter. They failed to break into the US and Europe so far. But that might be related to other things.

 

And in downturns you can just put your equipment (that keeps it value relatively well) in storage. There isnt much difference between models now and 20 years ago.

 

[Hielko]

I don't think that is a particular convincing argument. Sure, the threat of new competitors entering the market is low, but that is not what they have to fight against. The problem is that they have to compete against the various alternatives that clients have to obtain/sell equipment; that will always impose an upper bound on profitability, and limits the depth of the moat.

 

Having some economics of scale doesn't necessarily mean that you do have a moat. If you think about it: those scale economics is exactly what they are selling to clients and without it they wouldn't be able to offer a good value proposition. So you have to ask how much of those scale economics are required just for the business to offer an average return to investors?

[yadayada]

I dont know what you mean by alternatives? They got more then 50% market share. I dont know the competition, but if they are small, they have scale advantage so they are basicly low cost providers and can probably provide better service? There will always be demand for rental dump trucks and bulldozers, some times more then others?

 

If they are competing with one or more other large firm, then this is pretty much a rational oligopoly and it is difficult for new players to enter.

 

large capital requirements matter if you cant really get decent returns if you enter too. Their average returns is exactly what helps provide the moat in combination with large initial capital requirements, and need for a reputation.

 

Let's say that you need 600 million$ to enter this industry to establish economies of scale. Now you need to undercut price to steal customers. And the spread is already pretty small. And Emeco will probably lower prices too then. That is why it seems to me that a small spread and very large capital requirements keeps out new players. Anyone with half a brain could see that if you move 600 million$ of dump trucks and bulldozers into Australia now,  you won't really make a return on leasing them. So im not too afraid of that.

 

Also reason why they need to keep investing in downturns so market share wont be stolen in good times I guess.

 

And if you ahve to move them into Australia you pay like 3% of moving costs alone. And if it fails another 3% to move them out. And infrastructure to store them etc. ANd you make a shit return the first few years.

 

At least this is my hypothesis why these leasing industries of large equipment (with some kind of added service or differentiation) seem to be rational oligopolies most of the time.

[ukvalueinvestment]

I think Hielko is talking about pricing power. Emeco don't really have it because if they jack up prices, customers might find it preferable to buy equipment themselves or source it in other ways (share with other mining companies?)'.

 

As I bought at a massive discount to tangible book. I see this as a liquidation of inventory/reversion to mean story.  Not too bothered about moat, just need to know that there will be a reason for the company to exist in 5/10 years time.

[Myth465]

Good post

 

http://alphavulture.com/2014/05/20/portfolio-transactions-ehl-ax-stpfq-pris-ab/

[yadayada]

yeah but they will not liquidate in this enviroment. Debt is due in 2019. So like 4.5 years to go. Net debt is lik 330 million? THey will generate more then 100 million in net cash this year. And they sold this equipment in the worst enviroment and time ever pretty much. I doubt the rest of their equipment gets a discount this big, especially if they liquidate slowly over the next 5 years. If you assume a 40% discount, that is already 125 million in equity.

 

And in 2012 they generated 250 million in net cash. So one good year between now and 2019 and debt is wiped out and the stock will rerate big time.

 

Net asset value is only a risk if there are covenants or if they planned to liquidate the business soon, neither is the case here. And since asset value depends on the enviroment they are in, current net asset value is not very relevant.

[writser]

Net asset value is only a risk if there are covenants or if they planned to liquidate the business soon, neither is the case here

I'm sure they didn't plan to liquidate the Indonesian business either.

 

As I stated before, you have a different way of looking at this investment. Everybody agrees the upside is there. The thing is, the latest charges show that if things don't go as planned the book value of their assets could be overstated. In other words: if more things go wrong you are potentially left with $0. Based on previous transactions it seemed that even IF things went wrong, you could at least recover your initial outlay because liquid assets would cover debt + equity. Since the downside protection is no longer there he decides to sell. Might be too conservative for you but it's a consistent approach.

[yadayada]

yes but it makes zero sense to think of a hypothetical situation that wont happen and make that your downside case. Management doesnt own a large stake, that is kinda bad. They probably dont care as much about avoiding small losses like this in Indonesia. They do care about the share price because then they get a nice bonus.

 

So basicly this business wont  be liquidated at a quick rate anytime soon. management much rather gambles that mining will pick up before 2019. So to think what it would be worth right now if it is liquidated is pointless. It wont happen. There is always going to be demand for rental equipment in the future. And they are number one in australia at that.

 

And secondly, you dont know when they bought this equipment. They bought a lot of equipment in 2013,  180 million$ of equipment at a better price (in an enviroment where they sold older equipment at a ~20% discount to book).

 

So you also cannot say that they will get the same 54% discount for the rest of their equipment. Maybe Indonesia euquipment was bought in market peaks at worse prices then their equipment bought in 2013 and 2014?

 

Plus maybe that equipment was v old and gets bigger discounts in a market like this compared to new equipment?

 

[writser]

Again, you are probably right but it's just a completely different way of looking at the investment. You look at the upside: management gambles on mining to pick up, there will always demand for rental equipent, the Indonesia equipment could be a one-off and other equipment could be worth a lot more, this time they could have sold at a bigger discount due to market conditions. Management could have bought at market peaks (which would be a bad thing in itself). Look at all the assumptions you make in your previous post.

 

Whereas AlphaVulture looks strictly at the facts: things went bad in Indonesia and they were forced to make charges of a magnitude that would wipe out equity completely if more shit hits the fan.

 

I think you overestimate your ability to predict the future by assuming 'it makes zero sense because it won't happen'. I also think you overestimate the moat they have. AlphaVulture might also make a faulty judgement about the future of the company but at least he is erring at the conservative side. Emeco could be a nice speculation (I still hold a small position) but it is not a strict value investment with a margin of safety anymore.

[Hielko]

It's pretty optimistic to characterize the loss in Indonesia as a small loss imo. It's a 150M market cap company with a 50M loss! (most non cash, but still)

 

And sure, this isn't going to get liquidated, but that doesn't mean that you can't get in serious trouble as an equity holder. EBITDA this year will be between 72M and 75M. Their interest expense is 33M/year and they do require some maintenance capex for their fleet (17M in first half of 2014, annualized that is 34M). Take EBITDA en reduce it with interest expense and maintenance capex and you don't get a very high FCF yield.

 

IMO things will have to improve for this to be a good bet. And sure things can improve, and they are doing the right thing by cutting costs. But things can also get worse, and when things get worse there is no safety net.

[yadayada]

Again, you are probably right but it's just a completely different way of looking at the investment. You look at the upside: management gambles on mining to pick up, there will always demand for rental equipent, the Indonesia equipment could be a one-off and other equipment could be worth a lot more, this time they could have sold at a bigger discount due to market conditions. Management could have bought at market peaks (which would be a bad thing in itself). Look at all the assumptions you make in your previous post.

Well since management has zero incentive to destroy a lot of value here (and the shareprice) because of their bonus, it is unlikely they will wipe out equity and not hope the market turns up. It just makes zero sense for them to do that. It would be like shooting yourself in the foot. So you really have to look at what will happen in 2019 if mining sector hasnt turned up by then and the bond is about to mature. You have to see how much cash they generated by then to pay off debt.

 

And even then, if it is turning up, but they dont have enough cash, they will just be able to refinance it, instead of liquidate.

 

If things really get a lot worse in the next year, then they can sell of some equipment, so again total liquidation value won't matter. You honestly think management will just liquidate the entire bunch in a bad market because 'aaw fk it'? Seems to me their incentive is to survive for better times. THey also have about 40 million$ of cash now.

 

So if things get worse, it will only make the upside less because they had to sell of more equipment at a big discount.

 

If the market for this type of service disapears alltogehter (which seems very very unlikely) given that they are the 3rd largest mining country in the world, and Emeco holds dominant market share. But if that happens, then yeah i guess downside will be about 100%. But that just seems very unlikely to me. People will still want more coal, ore and Zinc over time. And the Canadians will still need extra bulldozers and trucks for their fracking sand.

[ukvalueinvestment]

As the company has turned off Capex, lots of unused equipment will just be used to replace worn out existing used equipment over the next three years.  Think of it as the company having prefunded and already done its replacement Capex.

[writser]

I hope you guys are right but I still think your thesis is mostly built around the expectation that things 'don't get worse'. If the same thing happens in Australia as it did in Indonesia they're pretty much gone. You say: impossible, I say: I don't have a clue. If they're forced to sell equipment (together with all competitors, so presumably at huge discounts) in a prolonged downturn they're in trouble. If they're in trouble people won't be very eager to refinance their debt. Already Moody's lowered their outlook for Emeco. Their leverage here is not something you can just ignore because everything will be ok in the long term.

 

Obviously management will try not to destroy value or liquidate the company, that's not the point. Point is just that the assumed margin of safety might not be there. If that wasn't really a reason for you to invest in Emeco anyway then nothing has changed.

[ukvalueinvestment]

The company is diversified across commodities and has some geographic diversification.  The scenario you talk about is some sort of Chinese economic disaster.  That would hit a great many companies and all indices around the world.  I think that disaster scenario is pretty much priced in.

[yadayada]

http://www.economist.com/news/business/21594260-government-risks-export-slump-boost-metals-processing-industry-smeltdown

that might ahve something to do with politics in Indonesia. And if you look at page 13

http://www.emecoequipment.com/upload/pages/annual-reports/appendix-4e-and-2013-annual-report.pdf

 

28% of fleet was in Indonesia, but only contributed 13% to ebitda. So it was a bad deal anyway. The other area's dont look bad. Chile has v high utilization.

 

But in australia you have coal mining, and close proximity to Asia. Their coal reserves are still huge, and demand for coal is likely to trend up in the future from here on. Unless Asia somehow figures out some alternative magical powersource, and also becomes less corrupt to not go after the cheap powersource that coal offers.

 

Coal was like 41% of revenue in 2013. So demand for rental equipment to mine coal will probably go up? But now you have a temporary slump due to no new coal plants in the US and overcapacity.

[writser]

Look, I'm not trying to go in specifics, I don't think we have an edge in knowing the future of the mining industry. For sure I don't have one. I'm just pointing out that _IF_ something goes wrong (key customer leaves, mining slump, government bans oil sand fracking, whatever) chances are that you're getting into serious problems - as was pointed out in Indonesia. What this company is doing is highly unpredictable (revenue declined 50% YOY, EBITDA declined 66%, FY estimates have been revised downwards multiple times, who saw that coming a year ago?) so I think it's a bit overconfident to be so sure about the future.

 

Before the Indonesia problems I thought the company was also valuable based on its asset base, now I'm not so sure about that. And for me, if I have to value the company as a going concern only I'd like to be sure it will be around in 5 years (and more importantly in this case, without dilutions, restructurings etc.). Again, I'm long as well, just trying to disprove my thesis instead of reassuring it.

[ukvalueinvestment]

I too have no edge and no idea.  I do know that I bought at 0.35 of tangible book and that FCF will be above 100mln this year because depreciation is far above CAPEX and that this has been the worst year in 12 for mining.  The company has time and zero covenant pressure.  reckon the odds are in my favour and if I keep finding bets with good odds over time, I will do well.