SKE half yearly, page-88

Wolfy,
Good bit of financial analysis, thank you.

Interestingly, I am thinking somewhat the opposite to you, I’m on a buy tack with the stock, having a view that the time for shorting the stock is behind us.

By way of prefacing my thinking on SKE, I note that I have some precedent with the stock, having followed it – without owning it – during the crazy acquisition-mania of the mid-2000s where the management of the company at the time spent an eye-popping $300m on acquisitions in a 30-month period ending in December, 2008.

I watched with bemusement how a company that was essentially debt-free in 2006 ended up with $300m of net debt by the time the GFC struck two years later (it would have been $400m had it not been for a series of equity raisings fortuitously undertaken not long before the GFC took hold).

NIBD went from 0.1x in JH2006 to a crippling 4.4x by JH2009, necessitating a $100m emergency equity raising at punitive cost, right in the peak throes of the GFC.

It was following this partial re-capitalisation of the company that I started acquiring shares over the course of 2010, especially after the FY2010 full-year result, and averaging an entry price not dissimilar to today’s current share price.

The reason I bought was purely on the basis of a deleveraging story.

And indeed, two years later (JH2012) NIBD-to-EBITDA was back down to 0.3x (from 2.5x @ JH10), and the share price had doubled. (Of course, Operating Profits had also increase some 50% over the two year period, which I thought could happen, but I wasn’t banking on it. The bigger driver of the post-GFC, bottom-line recovery was the lower interest expense, from $27m in 2010, to less than $4m.)

Then in 2013, ostensibly in order to plug the earnings hole that was emerging from the end of the mining boom, the acquisition pendulum started to swing back the other way again.

And just like had occurred in 2006 to 2008, the company has over the past two years over-acquired and has put the balance sheet under pressure at the very time that margins are being pressured.

When the $75m acquisition of Broadsword was made in July 2013, I was unimpressed. In contrast to SKE’s largely catch-and-pass, variable-cost, and capital-light core business at the time, in Broadsword they had bought what looked like a fixed cost business that was both maintenance- and capital-intensive and had no pricing power.

But I held onto my shares, notwithstanding.

And then, in November 2013, SKE announced a $34m bid for Thomas and Coffey (THO), claiming to have paid an EV/EBITDA multiple of around 4.8x based on EBITDA of $7.0m.

Trouble is, based on the little I knew of THO at the time, it didn’t strike me as anything approaching a half-decent business. My understanding of the business that SKE acquired was that it was a maintenance outsourcing business, whose fortunes largely depended on the variable whims of whether its major customers wanted to do things themselves or to get outsiders to help them do it.

And when I conducted some research on the company and its financial track record, I came away even more critical of the quality of the thing my company had just acquired.

THO’s historical financial performance was nothing short of acutely volatile, with wide swings in operating profits from year to year.

Most alarmingly, as I researched the business and measured how much (or how little, as the case was) shareholder wealth it generated:
I learnt that over its 16-year listed life, THO generated a cumulative total of $24m in Operating Cash Flow; Investing Cash Flow consumed $30m over that timeframe. The company had paid dividends totalling $25m, but it had raised almost the exact same amount in equity capital over its listed life, causing its Outstanding Shares on Issue to rise from under 20m in 1996, to 115m when it was acquired by SKE. That equated to a compound annual average increase in Issued Shares of over 11%pa (!), which is some hurdle for total profits to grow before they are able to do so on a per share basis.

And they were paying 50% more than this business had generated in Operating Cash Flows over more than a decade and a half. And one that had consumed it all, and then some.

SKE’s share price was still around $3.00 at the time, close to its post-GFC high. The market, clearly, wasn’t too concerned with the strategy.

But I wasn’t happy; if Broadsword was a 5 out of 10 business, then THO was a 2 or 3.

And I had seen this “Acquire-Desperately-to-Plug-Looming-Earnings-Holes” movie before. They always end badly.

It was disappointing that the very same SKE management team that had presided over a period of capital discipline resulting in balance sheet turnaround and repair, had now spent almost one-six of the company’s market value at the time on some dubious acquisitions.

So, duly miffed, less than a week after the announcement of the THO deal, I had sold all my stock in SKE.

And then, after all the pain and hard work over the preceding few years in getting the balance sheet repaired started to become undone; NIBD-to-EBITDA was back over 1.5x at the FY14 interim result (DH2013), compared to 0.5x just 6 months earlier.
And that was even before the impact of the THO acquisition, which only settled in February 2014, as well as $16m in deferred consideration for Broadsword.

The rest is history: today the company has Net Debt of $220m compared with current annual run rate EBITDA of around $100m (so 2.2x NIBD-to-EBITDA).

And the share price is a lot lower than one dollar than it is to three dollars.

(Truth be told, I recognise that I was very lucky in selling when I did, and I probably got the sell trigger right for the wrong reasons. I was selling because of a sense of unravelling capital discipline, when the real things that have affected the share price have been the collapse in Workforce Services margins – to an all-time low of 2.4% - which I didn’t expect, as well as the collapse in the oil price – which I, obviously, also didn’t forecast - and what that might mean for the outlook for the Engineering and Marine business)

We know that – absent any further acquisitions (which is hopefully a safe assumption) – it is unlikely that EBITDA will be higher going forward. So it is going to require organically-generated surplus capital to reduce the gearing.

And this is why I am attracted to SKE as an investment (at the right time, mind!): it is a significant generator of surplus cash, with Operating Cash Flow exceeding Capex Plus Payment for Intangibles (which I think is really a form of Capex) by a factor of 4 times.
For context:

• SKE has never recorded negative Free Cash Flow in any financial year (even the GFC saw FCF breakeven).
• Over the 12 years that I have maintained a financial model for SKE, the company has generated a cumulative total of $600m in Operating Cash Flow, of which just $155m was consumed by Capex and Payments for Intangibles.
• It has paid over $200m in dividends.

The problem that the company has always had has been that the ample surplus capital it has generated has been injudiciously deployed by a succession of management teams: over $450m (!) of acquisitions have been made over the last decade, most of them second-rate businesses and almost exclusively made precisely the wrong time in the cycle: they’ve always bought at the top of the cycle when prices were their highest, only to arrive at downturns in the economy, when they should have been buying assets on the cheap, with too much debt, so they couldn’t.

So why, then, am I a buyer of the stock at current levels?

Firstly, it “feels” to me like we are very much at a similar point in the balance sheet cycle of the company as we were during the GFC:
The balance sheet is less pristine than it was two years ago, but at NIBD-to-EBITDA of 2.2x, going to 2.5x possibly, that’s still nothing as acute as the 4x level reached during the GFC.

However, and this is where I differ from a previous poster, I think that there is already something of a doomsday scenario being priced into the stock (more on this below).

But the first very important thing that needs to be understood is the acute seasonality in Operating Cash Flows (mostly a function of customer payment timing): The company generates almost all of its Operating Cash Flows in the June half, with December-half cash flows always much weaker, and often even negative, as the period below shows, where June half Operating Cash Flows total almost $355m, compared to December-half aggregate of ~$60m:

JH09: $70.9m
DH09: $3.1m
JH10: $30.9m
DH10: $21.6m
JH11: $48.1m
DH11: $41.2m
JH12: $60.6m
DH12: -$3.9m
JH13: $65.7m
DH13: $1.4m
JH14: $61.5m
DH14: -$4.5m

And for the half just ended, Working Capital-to-Sales finished up at 9.1% which is an all-time high, but includes significant working capital investment in the ramp up of the Siapem contract which, I estimate added 75bp to WC/Sales. Absent that, the December half was not at odds with the usual seasonality in working capital:

Working Cap-to-Sales (Last 6 months’ Sales, annualised)
DH02: 8.5%
JH03: 8.1%
DH03: 8.5%
JH04: 7.7%
DH04: 8.4%
JH05: 7.3%
DH05: 6.2%
JH06: 5.0%
DH06: 8.0%
JH07: 5.5%
DH07: 8.2%
JH08: 5.5%
DH08: 6.7%
JH09: 5.2%
DH09: 6.0%
JH10: 7.1%
DH10: 8.0%
JH11: 7.7%
DH11: 7.6%
JH12: 6.4%
DH12: 8.1%
JH13: 6.5%
DH13: 8.2%
JH14: 6.8%
DH14: 8.4% (excl. +- 70bp for Saipem)

(December half WC-to-Sales averages 7.8%, considerably higher than June half’s 6.6%.)

With WC-to-Sales expected to seasonally reduce in the current half (I have assumed 7.5%, for the sake of conservativeness), I expect Operating Cash Flow for the half will be around $65m to $70m.

Out of that, $15m will be consumed by Investing Cash Flow (Capex = $6m, Intangibles payments = $2m, Deferred Consideration Payments = $7.0m), and dividend payments will account for a further $18m
Which will leave FCF of some $35m to retire debt.

So I expect NIBD @ 30 June, 2014 will finish below $200m, possibly even below $190m, compared to $220m @ 31 Dec 2014.

But what about beyond just the current financial year?

Some broker forecasts that I’ve seen put EBITDA and EBIT for FY2015, FY2016 and FY2017 as follows:
FY15: $99m/81m
FY16: $88m/70m
FY17: $85m/$68m

Based on these forecasts, and assuming a 50% dividend payout ratio, NIBD will fall to around $180m by 30 June 2016 and $165m by 30 June 2017.

This means that NIBD-to-EBITDA would remain relatively constant at around 1.9x to 2.0x, which would be imminently manageable, I think. (To give some idea of the sort of balance sheet flex capability, if – hypothetically - the dividend was to be cut, then NIBD-to-EBITDA would fall to 1.8x by June 2016 and 1.4x by June 2017.)

Most importantly, for purposes of looking at SKE as an investment prospect, it is currently trading on a FY2016 P/E multiple of 6.9x, an EV/EBITDA multiple of 6.1x and an EV/EBIT multiple of 6.1x (equivalent to a FCF yield of around 16%)

And for FY2017, the P/E = 7.6x, EV/EBITDA = 4.9x, EV/EBIT = 6.1x.

On any of these valuation metrics the stock is either significantly undervalued, or it is pricing in a significant deterioration in financial performance over the next two years, which analysts have still not factored into their forecasting.

My own opinion, having seen many situations like this in the past is that it is a case of 90% of the former (the stock is fundamentally deeply undervalued) and 10% of the latter (it is still cum-downgrade in the eyes of the investment community).

Another way to look at this sort of situation is to ask the questions:

1.) What is a fair set of valuation multiples to pay for this sort of business?
2.) Based on those multiples, what is the current share price implying about future earnings?

For part 1), let’s not kid ourselves, this is not the world’s greatest business. Far from it. It is cyclical, operates as skinny margins, has little pricing power and the only way it can grow through the cycle is by acquisition (on which it has not executed very well.) Its redeeming feature is that it consumes very little capital relative to the cash flows it generates.

With little doubt, it deserves discount-to-market valuation multiples.

EV/EBITDA of 6.0x and EV/EBIT of 7.0x (corresponding to pre-interest FCF yield of 14%) “feel” about right to me.

And to get to those multiples (by FY2017) requires EBITDA of $73m (from >$100m run rate today) and EBIT of $63m (cf. $87m current run rate).

So, theoretically, that’s a near-30% collapse in operating profits which is required to justify the current share price.

For further context, that would leave the company’s EBITDA and EBIT at levels equivalent to those experienced during the heart of the GFC…, and that’s even after around $15m of EBITDA and EBIT have subsequently been "acquired".

So the share price is factoring a real doomsday scenario, by my reckoning.

Of course, as I said, knowing the tardiness of broking analysts, their earnings forecasts for SKE are probably still too high, and the dividend is, indeed, highly likely to be reduced going forward.

As these events happen, the share price may indeed twitch downwards a few percent, but I think – based on the analysis sketched above - that overwhelmingly most of the downside is behind us.

When exactly intrinsic value might be restored to the share price, I don’t exactly know.

But I have started to buy some stock in recent weeks, albeit with only a modest level of conviction.

Any thoughts – especially countervailing ones – are welcome.