Thanks. Your three questions for the prospective investor are, of course, right, but i think you run the risk of missing what i think could be unfolding beneath the surface with Matrix (pardon the pun).
Their bread and butter for years was building buoyancy modules for newbuild ships - it's an inherently lumpy business where the top line is inextricably linked to the vicious cyclical swings in oil producer/explorer capex budgets, i.e. when oil prices and optimism are high, the demand for rigs is high, so the floater fleet owner/operators furiously commission the construction of new rigs to keep up, and Matrix is well-positioned to profit handsomely; conversely, when oil prices and optimism are low and the newbuild cycle goes south, Matrix's revenue heads south quickly. And remember that this impact is felt even more starkly at MCE's bottom line, given the inherent relatively high fixed cost / high operating leverage dynamic at play with just about any manufacturer. There is, of course, a decent time lag in the whole thing - the time between when a floater operator (who hires out its ships to oil explorers / producers) commissions the construction of a new ship, to when the shipyard completes construction and fits Matrix's buoyancy products prior to deployment, is at least two years, and maybe even three or four. Both the end user market (i.e. explorers / producers) and Matrix's direct customers (the floater operators that contract their ships out to the end users) are quite concentrated, and this is due to the capital intensity and specialized nature of the enterprise - this shows up in the concentration of Matrix's revenue base, which is significantly more concentrated than i would ordinarily like (just 3 customers represented 64% of MCE's 2016 revenue!).
With this in mind, when you look at chart 2 on p14 of their FY16 annual report (which shows construction of newbuild drillships), it becomes obvious how severe the downturn in MCE's core market has been - about ~25 newbuild ships p.a. were being constructed on average from 2009-2011 (probably as a delayed response to the +$100 oil per barrel prices in 2007-2008). This level of activity was a classic overbuild cycle (they're always obvious in hindsight) - it was predicated on there being an ever-expanding demand for oil rigs (and, by implication, a perpetually high oil price) because, with a useful life of up to 30 years (sometimes even longer, depending on the technical specifications of the rig and its intended use) and a total market size of 250-300 rigs, it clearly doesn't make sense to be growing the rig market by ~5-7% p.a. net of natural attrition (retirements). Nevertheless, that's what happened in the past. Of course, to correct for their overbuilding in the past (which inevitably led to an oversupply and has now crushed utilization & day rates), the floater owner/operators have precipitously slashed newbuild orders by about 75% from their peak, such that now only about 5 newbuilds p.a. are forecast to be constructed through 2020 (according to the same chart). A 75% reduction within 5 years in the core addressable market, for most businesses, would be enough to put quite a few businesses into the corporate graveyard.
Now, maybe i am giving MCE management too much credit here, but it looks to me like they saw this big slowdown in newbuild orders coming a number of years out and took action by, among other things, focusing on the less volatile replacement buoyancy product market (which can be retrofitted to existing floater rig deployments). I am probably the furthest thing from an engineer you'll ever meet, but i have read the technical specifications (and watched the youtube video...) for their LGS product, and according to their own pronouncements an LGS buoyancy retrofit can save up to $15m per rig, per year, in reduced downtime, versus a traditional buoyancy system. If those sorts of numbers are even close to being correct, then why wouldn't floater fleet operators spend what i would guess is a handful of million dollars to retrofit a rig, knowing that retrofit has a payback period of perhaps even less than a year? Seems almost too good to be true....
If the technology is as financially beneficial as MCE claims, then i have to believe that, as MCE said in its 1HFY16 report, "within a few years...LGS will dominate the market". That's very strong language for management to be using, particularly the management of a business which serves a market as depressed and down-and-out as the O&G exploration market currently is. Should that sort of language be given credence? I would really hope that MCE, as the world's leading supplier of buoyancy products (in their FY15 AR they said they had >50% market share in the newbuild market), having invested millions of dollars and a number of years developing and testing the LGS system, would know what it's talking about. Subsequent to that statement (in February 2016), they deployed their first LGS in June 2016, so the engineers now have 6 months of 'live' data to feed back to their capital budget committees in justifying (or not) the capital decision to retrofit LGS.
If one actually believes MCE management's pronouncements on the benefits of LGS (i.e. that it will "dominate" the market within a few years), and if you believe that LGS is going to be a higher gross margin product than MCE's existing suite (1HFY16 report, footnote 7: "value in use calculation assumes an improved gross margin from the introduction of the LGS into the overall product mix with a resultant improvement in overall gross margin"), then i don't think one really has to worry about the exact timing of the recovery. The exact timing of the recovery, to me, seems less relevant if we work within the general parameters given by management that:
- MCE can at least break even in FY17 (according to their Nov 2016 AGM update) based on existing work on hand, with potential for positive earnings surprises as new orders are won. I see this as a decent achievement given FY17 will probably be the earnings low point for them (their well stabilization and SURF products are on perhaps a 6-12 month cyclical lag to the oil price, and their buoyancy business is on an even longer lag), given the oil price stabilized in the second half of last year;
- LGS has a large, addressable market, and it is expected that it will capture a large share of this addressable market within a year or two; and
- LGS is a higher margin (more profitable) product than MCE's existing product suite.
The way i summarize things is to look 2-3 years out and ask myself, "what are some very broad parameters for where the business could be?", and i map out three scenarios:
1) Bear: LGS is a flop (management credibility out the window), SURF and well stabilization products tick along but not sufficient to really drive profitability, no cyclical uptick in newbuild ship orders to drive (highly profitable) traditional buoyancy suite production. Business here is probably doing in FY19 what it might be doing in FY17, i.e. making a repeatable, small profit. If this transpires, then paying $40m for the business today probably doesn't make sense, but the capital loss wouldn't be intolerable. I would consider this a very dark scenario for this business (and, by implication, the broader O&G sector).
2) Base: Some LGS success underpins gentle revenue improvement relative to FY16 and, with it, some operating margin improvement; some additional newbuild orders come through. Revenue here might be below what they did in FY14-FY15, but above FY16, slight margin improvement attributable to LGS, maybe they are doing underlying EBITDA in the mid-teens of millions here, in which case paying an EV today of $35m is fine.
3) Bull: LGS dominates market as per management statements and underpins revenue growth toward, or even above, ~$150m achieved in FY14-15, underlying EBITDA margins >15% experienced in FY15, maybe new build ship market is staging a nascent cyclical recovery, too. EBITDA in this scenario is greater than >$20m averaged through FY14-15, compares very favorably to today's $35m EV.
I have flirted with the idea of sitting on the sidelines now and waiting for confirmation of success with LGS (because that's clearly a big driver of value), but the problem with that approach is MCE could feasibly announce tomorrow a [$50m] LGS order (i picked $50m completely randomly, but it's not beyond the realms of possibility given there's apparently >$150m LGS quotes sitting out there), in which case the business is very clearly worth more than the ~$40m at which it is being priced today and, being a relatively rational market, the market price should almost immediately reflect that. I see MCE's current price as offering an attractive, risk-weighted entry point, on the proviso that: 1) MCE management is at least somewhat credible in their public pronouncements relating to LGS, and 2) the O&G services market is in a cyclical trough, rather than a permanently low plateau.
Great piece of work. Thanks for sharing.
One thing you havent commented on is management.
I remember posters who have met the man saying on HC some years ago that the CEO is insufferably arrogant as the trait that struck them. Often that personality type are unsuccessful in leading a great business as they dont get the best out of a team, and end up with yes men.
I dont know if they were true, but the posts seemed believable to me.
I see that as adding too much risk to investing in them, but I still watch out of interest as I think there is definate potential in the business. A new CEO would get me interested!!!!
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