Does anyone have an informed view on the fundamental value of MCE or, more specifically, potential upside? Seems to me to be a potentially interesting (i.e. somewhat asymmetrical) deep value play on an oil/gas sector recovery.
I see there being solid downside protection as a result of two factors:
1) Current market cap of $36m compares to a net current asset value of $35m ($45m current assets less $10m current liabilities), with only $3m non-current liabilities beyond that. So, if one assumed dollar-for-dollar balance sheet value on current assets, the net equity of (current assets - total liabilities) gives $32m, i.e. the present market cap attributes almost zero value to the ~$100m of non-current assets on the balance sheet, $82m of which is PP&E. I think one has to adjust the balance sheet value of current assets given US$10.9m of current asset value (~A$14m of $45m) relates to an overdue payable, whereby delivery of the product to the shipyard customer was pushed out to Jan 2019 at the end user's (Ocean Rig) request. That said, the most recent annual report stated that "MCE remains confident of receiving full settlement of this amount", but presumably on a delayed schedule. If i wrote that payable down by 50%, the current market cap is still only putting about $10m of value on MCE's $100m non-current asset balance sheet value, net of all liabilities.
2) Related to the above, this company is not going to broke as there's next to nil leverage on the balance sheet and they are at least breaking even in current trading conditions according to the most recent AGM update, despite being in the midst of the worst O&G sector downturn in a long time, meaning they are not likely to trade themselves into financial distress. The chances of a severely negative shareholder event relating to the company's capital structure (e.g. dilutive equity raise or bankruptcy type event) seem very remote, particularly given the CEO's family owns 24% of the company (reduced risk of misaligned agency cost events).
It seems to me like two of their three business lines are actually already at or near their bottom, or are returning to growth:
- Well construction products was crushed through 2015-2016 due to over-reliance on USA shale drillers, but they've had success in new markets (Asia & ME) and said in their annual report that they expected increased revenue from this division in FY17 (and the operating environment for end users, i.e. O&G drillers, has improved since the annual report).
- Similarly, their SURF division was crushed in 2015 when subsea exploration went through the floor. An increase in subsea exploration capex (already underway relative to the 2015-16 lows) will drive volumes for MCE's SURF buoyancy products, albeit with a time lag.
Their largest and most important business line, capital drilling equipment, has held up ok over the last few years as buoyancy products for newbuild ships continued to be delivered for orders placed before the oil price went into a tail spin. I suspect this division is still tailing down for MCE at the moment, and there's no near-term hope of a recovery in newbuild drillship orders (MCE's former bread and butter), but what gets me interested is the potential for a relatively quick turnaround driven by their push into the replacement market with their LGS product (first installed 6 months ago). It's hard to know exactly when this happens but i can imagine that, before the CFO or capital budget committee of any end user company (e.g. ship owner, explorer) gets the green light to splurge millions of dollars on a new MCE-built buoyancy system (and particularly in times when budgets are tight, as they are now), they'd need hard empirical data to back up MCE's claim that the LGS system reduces drag and makes the vessel more efficient. MCE state this pretty plainly in their 2016 annual report: "with the (LGS) in the water, results from its performance will be key to generating additional traction, with quotations in excess of US$150m submitted."
Piecing it all together, it doesn't take a huge amount of imagination to see a virtuous circle unfolding for MCE over the next few years, with obvious implications for the share price (which appears to me to be pricing MCE for near-permanent misery):
- Well construction and SURF products already stabilized and expected to grow through FY17-FY18;
- Underlying technology of LGS product, first installed in mid-2016, is validated, leading to conversion of at least some of the existing US$150m quotes to hard orders for replacement buoyancy products;
- LGS replacement buoyancy volumes underpin an increase in overall production and revenue. If this scenario plays out, i'd also expect better EBITDA margins than displayed over the last 2-3 years (when underlying EBITDA margins have been 12-15%), because: 1) there could be some gross margin uplift from selling LGS, versus selling commoditized buoyancy products, 2) the business should be more efficient given the substantial cost-out they've undertaken over the last 2-3 years (heavily reduced size of workforce, driven raw material efficiency gains, closed unprofitable Malaga workshop etc.)
- Strong cash generation with minimal stay-in-business capex requirements (D&A running ahead of SIB capex given their existing plant was constructed only 4 years ago) and zero leverage leads to management returning capital to shareholders - management has already signaled a willingness to do this through its 2015 buyback program, when they thought the business was undervalued at $0.80. If it was undervalued at ~$0.80, i wonder the extent to which management believe the business is undervalued now...
All of the above, by the way, doesn't really consider any potential long-term (albeit difficult to quantify) upside from:
- MCE's ongoing attempts to diversify the uses of their products into other fields (such as infrastructure or military use) - hard to know whether this will ever bear fruit or whether MCE will always just be a supplier to the O&G sector, but it's clear they are at least trying to diversify their revenue base (and have been for a while);
- A rebound in new build drill ship orders. This is very clearly not something that will transpire for at least 2 years (and probably more like 3-4), but it's worth remembering that it was MCE's bread and butter up until 3-4 years ago and can be a hugely profitable niche for them when the sun is shining - indeed, in FY11 when operating out of a less efficient plant, they did $175m revenue for $43m EBIT, with about 75-80% of their revenue coming from buoyancy products and the vast majority of that driven by new build orders. If you believe in cycles (as i do), then one day well into the future it seems probable that the new build ship market comes back and this could potentially put a rocket under MCE's production schedule.
So, while MCE has been poleaxed over the last 2-3 years as a provider to the O&G sector, it seems to me that the business is actually in significantly better shape than it was 3-4 years ago when the sun was shining:
- Debt fully repaid
- New products with technical edges launched, providing access to larger and less volatile market (i.e. focus on replacement buoyancy products for existing drill ships, rather than servicing the highly volatile new drill ships)
- Big cost-out program undertaken to drive efficiency gains
- Unprofitable operations ceased
Seems as though management haven't wasted a good crisis to improve the business. The key in all this is getting volume through their plant, driven by their LGS product being deployed as replacement buoyancy products for existing ships. If they unlock that (as management still seems confident of), the next few years could see quite a swift turnaround.
MCE Price at posting:
38.5¢ Sentiment: Buy Disclosure: Held
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