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.

Silver Chef -- Equipment Leasing

Silver Chef is an Australian company with a straightforward business model. 

Hospitality start-ups – new restaurants – are often starved for cash. They need to invest in professional cooking equipment but purchasing it outright is risky and ties up more working capital than they can spare. The typical piece of equipment costs $10,000. Silver Chef offers them a lease-try-buy option. They commit to leasing, for example, a Middleby convection oven and Silver Chef then buys it and rents it to them. The minimum lease term is one year, and they pay rent monthly, in advance. Banks require Director guarantees, Silver Chef doesn’t. If they can’t pay, the oven is repossessed.   

If their business succeeds, they have the option to buy that piece of equipment and are credited for some of the rental fees they’ve paid. Some do buy but most don’t – they continue to lease because the rent is off-balance sheet.

One can see how it’s a win-win for both parties. Besides, banks concentrate on large businesses, Silver Chef concentrates on small enterprises.

Silver Chef succeeds in making this model work. No one customer constitutes more than 1% of revenue, thereby limiting risk. It grows fast and grows profitably. 

It has the bright idea that the best customers may be franchisees of well-known, fast-growing brands, and it now targets the franchisees of Dominos Pizza, Subway, The Coffee Club, Nandos, Outback Jack’s Bar & Grill,   Gloria Jean’s, and Wendys (an ice cream franchise, not the hamburger chain). These customers subsequently make up a substantial share of its business, are lower risk, and present excellent growth opportunities.

Better, once embedded in these brands, word of mouth makes it likely that there would be some protection from  price competition waged by potential entrants into the equipment leasing space.

The next bight idea: since this model works well in hospitality, why not extend it to other sectors? Silver Chef establishes GoGetta in 2008 and does very well indeed. Earth movers, gym equipment, cash registers, hydraulic pipe benders, trailers, you name it. Same value proposition, same sized businesses, different sectors.

Anyway, here are the financials:

 (NB: Silver Chef's been in business since 1986, went public in 2005, and I don't have access to 2004 balance sheet information).

The above somewhat understates the profitability of Silver Chef's business. The cash recovery rate captures it better:

As an aside, I am convinced that, when Buffett looks at a stock, its CRR is what he calculates first, because it is so quick and so reliable. Consider, for example, this discussion of his investment in Mid-Contental Tab Card Co.

In any case, Silver Chef is in the business of turning purchased assets into cash and one can see from the table above is that it does that quite well and it's getting better at it as it grows.

So, that's where we are: Silver Chef is a simple easy-to-understand business, with a CAGR of 45% over the last eight years, earning its cost of capital, with an as yet 3% penetration of its potential market. It is selling in the market at a yield of 11.65%.

It's no growth value, at an 8.5% cost of capital, is close to AUD$5.15.  If you ask a Buffett-like question -- "Will I earn 15% on $170m of sales?" -- the answer is much more likely to be "yes" than it is to be "no". 

I'd venture that Silver Chef's minimum true value is in the neighborhood of AUD$12.

Disclosure: No position.

IMF (Australia) Ltd -- Litigation Finance

IMF (Australia) Ltd (IMF) funds lawsuits, primarily in Australia where it pioneered its business model and now dominates this niche activity. 

IMF is approached with prospective business by claimants or their lawyers, and elects to finance those cases that it believes will have a high probability of paying out three times its investment within two and a half years – about 3% to 4% of the deal flow.

Between its listing ten years ago, and June of this year, IMF’s performance has lived up to this objective: it has funded 137 completed cases, 93 of which were settled, 12 won at trial, and 5 lost. (In addition, IMF withdrew from 27 cases).  The average gross return on its investment in these cases has been 310% every 2.3 years.

And, with time and with the available funds that success has brought, the investment book has grown: the cases are bigger and there are more of them, even as the discipline that fathered the success – 3% to 4% of deal flow – has remained tight.  The benefits of learning are also evident – the time to completion, for example, has shortened, the case ROI strengthened, and the unallocated overhead shrunk as a percentage of revenue. 

That’s the business in a nutshell. Let’s now build up a valuation.

IMF has AUD$ 62.4 million in cash, a convertible debt liability of $35 million, and a net tangible book value of $52 million, or 35 cents per share. (The convertible debt will likely be paid off in December of this year).

In addition, the (direct and indirect) costs incurred in the current, unresolved case load are capitalized and carried on the books as intangible assets valued at $66 million. If the cases are resolved in a manner consistent to IMF’s past portfolio, the current caseload will generate revenues of (3.1*62 =) $192 million over the next two and a half years, of which 60%, or $115 million, will flow to the profit line. That’s an additional 79 cents per share in value, bringing us to $1.13.

Australia is, by now, a more or less mature market for litigation finance, and IMF has established a presence in New York to tap into the American litigation funding opportunity. In the United States, the deal flow is likely to be better, much better, and, as they say in litigation finance, there’s no business like flow business.*

The shares are trading at $1.50. For the extra 37 cents one would receive the proceeds of whatever new business comes IMF’s way, either in Australia or in the United States, from now until the horizon. As a point of reference the trailing diluted earnings per share is 29 cents. I think that's an unreasonably low-priced option on IMF's future cash flows.

In more conventional valuation language, IMF is a fast growing business, with 15% insider ownership,  paying out substantial dividends, returning 60% on its invested capital, and trading at an implausible EV/EBIT multiple of 3x.

*I made that up.