“Could the RCR Tomlinson collapse trigger bargains?
The collapse of listed engineering group RCR Tomlinson must have sent shivers through every value fund manager in Australia. If one of the flagbearers in the sector — reputable fund manager Allan Gray — can lose its 5.3 per cent stake in RCR, where next will the falling knife land?
Allan Gray was not the only fund manager caught this week when RCR went into administration: until very recently, RCR had been running a $2 billion business. Investors at all levels have been left stunned as the group that had been specialising in solar farm projects went into administration because it could not get bank finance.
RCR has been the worst story so far, but it is only one of a number of blow-ups this month that have hit the contracting industry.
Others include crane operator Boom Logistics, where the stock fell almost a third after a profit downgrade due to strike action, but has since partially recovered. Similarly, shares in mining services stalwart MACA got smacked 25 per cent due to increased labour costs, and one of the giants of the sector, Lendlease, fell 25 per cent after announcing cost blowouts in engineering contracts.
Before discussing whether any of these companies are worth buying (RCR excluded), it’s worth looking at how it came to this and how you can avoid owning an RCR at the wrong time.
The first thing to note is that the earnings of contractors are highly cyclical, which means they benefit from fast economic growth. Certainly, a key to much of the pain being experienced by these companies isn’t on their ability to get work, which we don’t think will be a problem for the next one or two years at least, it’s their ability to get profitable work. Put another way, it’s their inability to keep costs down.
But in my opinion, even more important is the folly of chasing growth for growth’s sake. When working out whether these stocks are worth investing in, the best place to start is the balance sheet. In their fixation for growth that most broking analysts have, they often ignore this particular arm of the financial statements.
A good way to look at contractors is using the company’s book value, rather than its earnings, to value the company. The book value is simply assets minus liabilities, or net assets. This is typically more stable than earnings because it’s a balance sheet item.
Lendlease might trade on a low price-to-book multiple after its big sell-off due to writedowns relating to cost blowouts in its engineering division, but that does not mean it’s good value. In order to assess this, we need to look at its future growth prospects. For a number of years now, this business has been globally diversified and has a $71bn development pipeline: once you factor that into the equation, this company looks great value.
Crane operator Boom Logistics is vulnerable with debt of $44 million, but it has reduced this debt from almost $90m only four years ago. Also, management is turning its operations around and increasing its utilisation rates and hence producing positive cash flow. There are still risks, but Boom at current levels is trading at almost half its net tangible assets and that’s cheap!
Like Boom, mining and civil services contractor MACA is facing cost pressures from increasing wages, which is an inevitable impact of a tight labour market driven by a strong economy, which is actually a good thing. Besides having been around for a long time, MACA has some $63m in cash on its balance sheet.
Because of their high fixed-cost base, these stocks have the operating leverage that can supercharge your portfolio’s returns. But as RCR shows, you have to be able to treat management optimism with a great deal of scepticism in order to profit.
Richard Hemming is an independent analyst who edits undertheradarreport.com.au
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