An Update on Emeco Holdings

Some news from Emeco this evening/morning:

"Emeco Holdings Limited (ASX: EHL) ('Emeco' or 'the Company') today announced the amendment of two financial covenants under the A$450m Senior Debt Facility, (the "Bank Debt Facility").

Emeco remains in full compliance with its current covenants. Amendments to the Gearing Ratio (Gross Debt: EBITDA) and Interest Cover Ratio (EBITDA: Net Interest) covenants were sought to provide the Company with additional flexibility and headroom and to provide balance sheet certainty while it pursues the debt reduction strategy in FY14.

Amendments will apply for the period to 30 June 2014 at which point the covenants will revert to current levels under the Bank Debt Facility. As previously announced to market, Emeco will not pay dividends or pursue other capital management initiatives prior to 30 June 2014, and has extended this commitment to providers of the Bank Debt Facility during the period to 30 June 2014.

Current and amended ratios are as follows:

	Current Covenants	Amended Covenants3
Gearing (Gross Debt : EBITDA1)	<3.0x	<3.5x
Interest Cover (EBITDA : Net Interest Expense2)	>4.0x	>3.5x

1 - Rolling 12 month trailing Operating EBITDA

2 - Rolling 12 month trailing Net Interest Expense

3 - Amended Covenants apply to the USPP Notes

Other key terms of the Bank Debt Facility, including pricing, remain unchanged and Emeco retains full access to the Bank Debt Facility. Emeco did not incur any fees or charges from providers of the Bank Debt Facility in connection with the amendment.

Emeco is focused on reducing debt and continues to generate strong cash flow with net debt reducing by
$25m in the first quarter from $415m at 30 June 2013 to $390m at quarter end. Through the combination
of further cash flow generation, working capital release, asset disposals and lower capex, Emeco will deliver further reductions in debt through FY14.

Stephen Gobby, Chief Financial Officer, said "We have been pleased with the cash flow performance of the business this year despite the tough operating environment. Our focus remains on maintaining strong cash flow over the balance of FY14 in order to further reduce debt and ensure that the balance sheet of the Company remains robust."

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This is a cash flow story: a bad business environment means Emeco sells off its inventory to generate cash flows; a good business environment means it rents out its inventory to generate cash flows. Emeco's rental fleet is best understood as inventory, which means that Emeco is, among other things, a "net-net".

Addendum November 20th:

An update and clarification of sorts. There's a post on this name at Alpha Vulture and the company has very recently guided between $90 and $105 million in EBITDA for FY 2014. Given that Chile and Canada account for $45 to $50 million of EBITDA, $90m in consolidated EBITDA means that Australian utilization rates have fallen off a cliff, to a third of 2012's figures and a sixth of 2011 figures. 

Alright, so this is where margin of safety comes in to play. 
--> Emeco needs to keep debt below 3.5x trailing consolidated EBITDA.
--> 90 million in EBITDA implies 40% to 45% utilization of its 813 machines
--> which means that it can sell off some of those machines 
--> so the question is, at what discount to book it will offload them.

Here's a sensitivity table relating cash flows from operations, net disposals, and discounts to carrying value on the one hand, to Debt/EBITDA ratios on the other:

Projected DEBT/EBITDA Ratios:

assumptions: operating cash flows = $90m EBITDA minus $30m capex mins $29m interest.

Can Emeco sell 2 machines a week at 40% discount to book? I think it can. And if it can, then you may consider that at the end of 2014 liquidation value will look like this:

That's why I'm long the stock. This is not Caterpillar. I should say that I'm a true believer at this point and I suspect that the conversation at Alpha Vulture would be more nuanced than anything I have to add.

Disclosure: I own shares in Emeco

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

More on Emeco Holdings

Some things it is helpful to know about Emeco:

“A large part of our sustaining capex is the replacement of machines at the end of their useful life. We can therefore naturally contract certain asset classes within our fleet where we see lower demand for them over the medium term and use the cash to retire debt. I refer to this as “right sizing” the balance sheet to the earnings of the business through the cycle.”

and

and

And a long presentation by the CEO here.

Disclosure: I am long Emeco

Portfolio Update

I’ve bought some shares in Emeco Holdings at ~AUD 0.310 (or <2x trough FCF). 

Emeco Holdings -- Equipment Leasing

Emeco Holdings buys earth moving equipment and leases it to businesses in the mining sector: iron ore, gold, coal, and copper in Australia, Chile, Canada and Indonesia. The company was founded in 1972 and, after a period when it was owned by a private equity firm, was floated on the ASX in 2005.

The business model should be familiar by now: like Silver Chef, Northbridge, and Northgate, the name of the game is specialization, risk spreading, niche market domination, and balance sheet flexibility.

Like Northgate, it over-depreciates. See here:

Or here, in figures provided by the company itself for the period 2009-2012:

Maintenance capex is therefore about 47% to 48% of depreciation. Knowing this allows us to build an accurate economic picture of the company:

So Emeco is worth AUD $1.43 per share (if we use the average operating profit over the last business cycle), or AUD $2.48 per share (if we use the average return on net operating assets and apply it to Emeco’s current installed capacity). The stock is trading at $0.47 – i.e. at either 1/3rd or 1/5th of its intrinsic value.

It is free cash flow positive and there are no covenant or liquidity issues. Hell, at $0.48, it is trading below liquidation value.

If you can break Emeco, hats off. I can’t.

Disclosure: No position.