Tuesday, July 2, 2013

Emeco's Downside

What will happen to Emeco’s valuation if there’s a material, permanent slowdown in mining activity?

It will reduce its inventory of equipment and shrink its working capital needs, thereby generating increased free cash. If revenue falls by 15% a year between now and 2016, the free cash flow schedule, at more or less 80% utilization and 36 days of working capital, will look like this:


Doesn’t this assume an orderly liquidation?
Yes, it does and for a number of reasons:

(1) Emeco is more exposed to mining operations than to mining capex (and therefore more exposed to commodity supply than to commodity prices);

(2) Under conditions of commodity price uncertainty, the benefits of leasing v. ownership are brought into sharper relief;

(3) Emeco is exposed to thermal coal (with its blue-chip customers themselves operating under long-term supply agreements with Japanese, Korean and Chinese buyers) as well as to gold, iron ore, oil, and civil construction;

(4) Emeco’s used equipment holds its value well, reselling at 15% above book value even in 2009;

(5) Pressure in the Australian rental equipment market will squeeze out smaller players first, thereby stabilizing rental rates somewhat;

(6) Oversupply of heavy equipment will shrink the supply of new equipment first, thereby cushioning the resale market from the effects of a sharp downturn in mining activity;

(7) Emeco’s fixed operating costs amount to ~$48 million, or 8.5% of current revenue, meaning that expectations of heavily negative operating leverage in case of a fall in revenues are misplaced;

(8) Emeco management’s incentive pay is structured around ROIC and share price which leads one to believe that the company will attempt to (a) reallocate existing equipment to more productive uses, (2) shed equipment at attractive prices, and/or (3) repurchase its shares at attractive prices;

(9) Three and six months ago, with the same information available to them then as we have now, the company was repurchasing a material number of shares at $0.53.  

Why does this opportunity exist?


My best guess is that the market has lost sight of Emeco’s place in the mining value chain, has overstated its fixed cost base, and has underestimated its cash flow levers. The Indonesian contract dispute has served up a profit warning that was perfectly timed to reinforce the market’s assumptions about its business.  

I am sometimes wrong but almost never in doubt so, as always, please do your own research.

Disclosure: I am long Emeco

16 comments:

  1. Well-written as usual Red. I like to wait for the fire-and-brimstone stage in commodity-linked sectors (the valuation of even great companies tend to be disappointedly brought down equally alongside the chaff during a stampeding herd), but this is on my tracking list now.

    By the way, I'm consistently amazed by the wealth creation track-records of equipment rental companies globally over the last 20-30 years. It's uncanny.

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    1. Thnaks, Sam, I think waiting for a possible fire-and-brimstone moment is the smartest thing of all. I've sized my own position as, if not a toehold exactly, then a foothold.

      I suppose equipment rental companies were best placed to benefit from the two big business trends of that time (1) the dis-integration of the value chain as their customers tried to focus on core competencies and whatnot, and the (2) the off-balance sheet nature of lease liabilities.

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    2. That's an interesting observation.

      I was noodling on this in my head for a while after marveling at some outstanding VIC ideas for equipment rental companies posted in the early part of the last decade. An aircraft leasing company, in particular.

      Some combination of marketing specialization with customers due to heightened brand awareness, increasing purchasing power over OEMs due to scale, "financialization" of purchasing behavior (your "off-B/S leases" comment phrased slightly differently), growth of LCC's, increasing affluence in Asia driving consumer demand for air travel which in turn stimulated government & private airline investment, and the raw unit economics whereby few upstart airlines are able to afford several dozen $50m aircraft purchases at one time. As Munger would say, this was the kind of lollapalooza we're looking for.

      Interestingly, you can also take away some interesting lessons from the poor Wesco acquisition of CORT in 2000. Some of it is 20-20 hindsight, but you can glean some important learnings about the discretionary nature of office furniture and the "temporality" (for lack of a better word) of most white-collar services enterprises through a full business cycle.

      Anyway, both are really good case studies of Michael Porter's eponymous forces.

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    3. Excellent comment. I hope to write a post on how equipment leasing companies turn a profit & fend off competition but the second para of your reply sums it up perfectly.

      I don't know that one can do well (long-term, above average ROIC) in the leasing business without offering necessary support services. Specialized support services --> reputation ---> stickiness ---> reputation --> virtuous cicle. In that light, since office furniture requires no meaningful support, I can understand how it may not make for a good business.

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    4. I'll share some more of my notes on various segments. It's interesting -- there are few "hard-and-fast" rules. More questions than answers, but some interesting things to ponder. I think the biggest key insight for me is in regard to the ASP of the equipment... Bigger ASP = better RoE for leasing company. Then again, note that it doesn't hold true for all segments -- see the slot machine leasing company. Perhaps it is the regulatory nature of certain categories... Hmmm. I may be on to something now...

      - Railcars (Buffett loved GATX for the 20% ROE it generated... What is it about leasing railcars that is so special?)

      - Airplanes (strong incentive for airlines to take good care of the equipment for both customer care reasons and regulatory reasons... i.e. regulators won't let you fly if the equipment isn't kept up, and you go BK if you cant fly)

      - Trucks (Ryder -- why did this company do so well?)

      - Casino slots (PDS Gaming -- this is a great niche! Regulated industry w/ tough competitive entry because a leasing company needs to get gambling license in every single state, growing volume demand, disparate Indian gaming customer base, strong incentives for casinos to lease due to high upfront capital costs for slot machine purchases, easy transferability of equipment if leasee doesn't pay, healthy customers)

      - Land-Based Storage Containers a/k/a "Mobile Mini" (scale allowed them to buy ocean shipping containers more cheaply than competition; even though it's a pure commodity industry, their "name brand" and distribution allowed them to get a lot better marketing than small mom-and-pops; cost $4k per container including fix-up and shipment, could borrow 80-90% LTV, and received rental income of ~$1k of rental income per year! Containers only depreciated ~2% per year, so very low maintenance costs too; it's all about keeping utilization >75% to be able to pay for box refurbishing and interest expense)

      - Restaurant leasing is a TERRIBLE market because your customers (small restaurants) are constantly going out-of-business

      - Photocopier leasing also turned out to be TERRIBLE but for a different reason -- the OEMs began to compete with the leasing companies like IKON

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    5. That’s a very good outline. Thanks, and I hope that people happen upon it so that they can put it to use someday.

      I think maybe that if we create a 2x2 with equipment/end-user characteristics on the x (ASP, credit risk, regulation, customer size), and lease v buy characteristics on the y (maintenance needs, service needs, residual value risk, balance sheet flexibility etc), a comprehensible pattern will emerge.

      So, for example, restaurant equipment is a credit risk story and profitability is going to be determined by how well one manages that. Like Silver Chef, for example. http://quinzedix.blogspot.com/2012/09/silver-chef-equipment-leasing.html

      It helps a great deal if each customer is operating on a knife edge while the customer’s industry as a whole is quite stable. Like individual restaurants or airlines where individual businesses go in and out of business but are simply replaced by other restaurants and airlines with the very same equipment needs.

      Ryder, otoh, seems to recognize that it’s a beneficiary of regulation and service complexity http://online.barrons.com/article/SB50001424053111904757804578036773617133936.html

      The danger for leasecos is when there's a certain concentration in equipment brand/type, extensive/regular maintenance requirements, and high/invariable residual value. E.g. maintenance is maybe ~50% of the value in the photocopier value chain (10% for the equipment, 40% for the consumables) so, when combined with concentration in brands, there’s a real temptation for OEMs to get in the game.

      Railcars – I imagine that it’s high ASP + high maintenance margin + high margins on daily & hourly rates + especially the local nature of the fixed cost base that limits direct competition from other lessors (or OEMs) with railyards in other places.

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  2. Hey red,

    What's your take on Chanos's point:
    http://www.buysidemetrics.com/?p=11072
    http://video.cnbc.com/gallery/?video=3000182758

    Kind regards,

    Michael

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    1. Hi Michael,

      On his specific point:

      1) I'd rather be long Emeco than short (or long) Caterpillar. Caterpillar has large fixed costs and Emeco doesn't. Caterpillar is exposed to mine development capex; Emeco not so much. Caterpillar has to spend cash on maintenance capex through the cycle; Emeco has only to stop buying equipment. Those differences are what makes Emeco an attractive proposition.

      2) A useful exercise for anyone considering a position in Emeco is to calculate Emeco's % exposure to Chinese construction and map out what happens to Emeco's cash flows, earnings and balance sheet if Chinese construction expenditure experiences a crash.

      3) The lazy (and imprecise) way to assess what happens is the following: He implies that global mining will return to 2006/7 levels. Emeco earned AUD $59m in 2006. Halve that, just for fun, and make it $25m. Add the cashflow from disposals, subtract the debt, and that's your downside equity value.


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  3. '13 EBITDA $188m and they spend $178m on capex.
    I wonder how they justify 'growth' capex when revenue was down 22%. hilarious.

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  4. There's an investment lesson in that comment. Thanks.

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  5. Hi Red. I compared the latest announcement from Emeco with your downside case. Expected FY 2014 EBITDA is A$90-105m vs. A$215m in your downside case. They still expect to generate FCF and pay down debt, but even the revised 3.5x leverage covenant could be tough to comply with (current net debt is A$377m).
    What's your take?

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  6. Hi.

    I was having a discussion about that today, as it happens.

    So,

    Emeco's at 377 in net debt now and, on the assumption that EBITDA comes in at 90, net debt needs to get below 315.

    EBITDA of 90 implies utilization rates in the 45% range, so half the fleet, with a book value of ~$380 million, is idle in that scenario.

    If they sell 1/3 of the idle machines at 3/4 the carrying value, they generate $95 million. Plus there is OCF of ~$20 million coming in ever quarter, even at the low end. (Working capital release is not likely to be terribly significant, in my view.)

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  7. In any case, probably worth breaking out a spreadsheet and calculating at what combination of disposals and discounts to carrying value the covenants get breached.

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  8. Thx for your reply. I'm a bit worried that used equipment prices might fall further, reducing potential proceeds from disposals. Using a sensitivity table, as you mentioned, might be the right approach.


    The stock is likely to remain very volatile until operations stabilize or markets get comfortable with the deleveraging of the balance sheet.

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  9. Since I've held it it's ranged between $0.16 and $0.34 so yes, if you can get comfortable with the sensitivities there's some room to benefit from the volatility.

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  10. And also,
    1) You may be interested in comparing Emeco with Seven Group's WesTrac segment. WesTrac is the Cat dealer in Australia and Seven group is quite well followed.

    2) Emeco's inventory is not so esoteric that one can't look up what comparables to its individual pieces are selling for in used equipment markets the world over. I haven't noticed any softening yet though, of course, it could happen in the future.

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