Struggling as I am to find new investment opportunities, once every six months or so I rummage through the detritus that is the mining services sector to see if there are any half-decent businesses that have been indiscriminately discarded by the market and that might be trading at cheap enough valuations.
At the outset, I’ll say that researching mining service companies with a view to investing in them doesn’t sit naturally with me.
The reason for this ill ease is that, generally, I don’t think mining service businesses make for good investments for the simple overriding reason that they lack any semblance of pricing power.
Because of the industry structure – where the mining customers are typically very large, and their suppliers are typically quite small by comparison - when the commodity cycle turns down the mining service sector cops the double whammy of both lower volumes as well as lower prices.
I think mining services companies can be divided into three kinds of activities, namely those that:
1) provide services involving intellectual property (e.g., consultants, engineers, trades, assaying services)
[Companies such as ALQ, LYL, LCM, SKE]
2) sell stuff to the industry (euphemistically, the “picks ‘n shovels” type businesses, e.g., consumables such as explosives, fuel, wear components, equipment spares).
[Companies such as BKN, ORI]
3.) build things or provide services involving heavy equipment (e.g., engineering construction, drilling contractors, earthmoving contractors, mobile crushing operators, crane operators)
[Companies such as ASL, DOW, EHL, LEI, MAH, MND, MRM, NWH, SDM, SXE, TSE, SWK, UGL]
Of these, the category that I have almost zero investing interest is #3.
Because while I can live with an absence of pricing power, which is endemic to this sector, what can’t be tolerated is zero Free Cash Flow in conjunction with zero pricing power.
(In fact, this particular category has many characteristics that are truly hostile to the creation of shareholder value: highly concentrated customer base, commoditised service offering, deeply demand cyclicality, volatile earnings streams, high capital-intensity, no pricing power, contract pricing risk, execution risk.
As a case in point, my observation for a company such as say, a contract driller, is that not only do shareholders see very little return during the cyclical lows because capacity utilisation is too low, but even during the boom times, shareholders get to share in very little of the profits because the company is always retaining capital to build and buy more drill rigs... and often the company’s management actually asks shareholders for money to expand capacity. And then when the boom ends, all shareholders really end up owning is a fleet of idle drill rigs rusting in an industrial lot somewhere in east Perth.)
So that leaves me with re-visiting, from time to time, the likes of BKN, ORI, ALQ, LCM, LYL, and SKE.
I looked at LYL just under a year ago, built a financial model and came to the view that the earnings base of the business needed some time to stabilise before an investment in the stock could be countenanced.
And besides that, even if earnings had fully re-based, the share price at the time of $2.70/share left me thinking that there was insufficient downside protection given the valuation multiples at which the stock would have been trading (~10x EV/EBIT and 14.5x EV/EBIT, implying 7% FCF buyout).
However, now at a price in the sub-$1.50 level, I have determined for myself that the stock is pricing in a scenario that is so dismal that it is highly unlikely to occur.
My thinking is as follows:
Starting with a look at the Revenue experience: well, it has been nothing short of tragic over the past 18 months as the mining boom has ended. In FY13 the company recorded Revenue of $245m; this year, it will be lucky to report $120m. And that’s even after acquiring $25m in Revenues during DH14 in the form of the ADP Holdings acquisition.
Commensurately, EBITDA has collapsed from over $30m in FY13 to what will probably be less than $5m in the current financial year. And that $5m is not really operating EBITDA, per se, but is almost exclusively derived from LYL’s share of profits from its 50%-owned Pilbara EPCM JV which is completing a project (something called Nammuldi, I believe) for Rio Tinto.
So “core” Lycopodium businesses are essentially making no money at the moment.
Why then – when the company is basically breaking even currently, and when it is unlikely that demand for Lycopodium’s services is going to go up in any meaningful way any time soon - do I like the company as an investment opportunity, in that case?
Well, let’s analyse what’s happening in the guts of the P&L:
Starting with the Revenue line:
If we strip out the $13m of Revenue that came with the ADP acquisition during the prior half (ADP was only acquired with effect from 1 October 2014), then “core” Revenue (i.e., excluding the impact ADP Holdings) in DH14 fell by an astonishing 51% on pcp (DH13) and by 19% on the prior period (JH14), to around $46m.
Annualising that suggests that the core business is doing around $90m to $95m pa in Revenue today.
For context, that’s about the same level of Revenue as the company as generating in 2006, soon after it listed.
[Pretty sad, but that’s the nature of acutely cyclical businesses. Their revenues go up, and as sure as night follows day, they go down again at some stage, and vice versa (which is why one should never buy those businesses during the “up” periods).]
Now let’s look at the EBITDA:
The big difference between the last time that Lycopodium revenue was sub-$100m, and today, is that the company was in 2006 generating EBITDA of some $12m. Today, as discussed above, it is making sweet zero.
Why is this?
Well, whenever people businesses don’t make money it is because – self-evidently – there are simply too many people, or because the people earn more than the underlying economics of their businesses can bear.
In LYL’s case, it’s probably a combination of the two, but that there is a mismatch between Revenue and Costs is clear to see:
In 2006, Employee Expenses (excluding Contractors) was $34m pa; today, annualising DH14’s result, it is running at $40m, and
Administration and Management Expenses were around $7.5m in 2006; today this expense line is annualising at almost $14m (although, to be fair, it has fallen from ~$20m in FY2013).
These are manageable expenses and, needless to say, if they can be brought even halfway back into line with precedent, it would - all other things being equal - result in $6m to $6.5m of EBITDA appearing instantly.
And $6m of EBITDA is obviously very meaningful in the context of an Enterprise Value of just $18m.
For confirmation of this potential, another way to look at this is to view LYL as it stands today in its entirety, including ADP, and to look at what is happening to the trends in all the “people costs” put together:
The impact on the slump in mining sector business is clear to see in the severe deterioration in this key operating metric after 2012 (the peak in the cycle).
But most importantly, I think, is that the most recent half showed that the cutbacks in headcount is starting to kick in, with the metric improving favourably.
This lagged effect between Revenue and Costs is not unusual: it takes time for management to respond to downturns in their business… first, it takes them time to realise it’s actually happening, then they tend to do nothing in case the downturn is merely temporary, and when they finally act, it takes time for their actions to take effect [(and invariably, the action to address the cost base is a costly one (redundancy payments, lease terminations, restructuring exercises), which has the effect of dampening financial results even further.]
(As an asides, it means that business often end up “over-earning” during the good times, while their earnings tend to be understated during lean periods, such as now. As a case in point, we know that the LYL DY14 result included restructuring expenses (quantum undisclosed) which were taken above the line, and not stripped out or identified as abnormal items. And indeed in the current half the results might be again impacted by such costs, but at some stage they will cease to recur. But until then the financial performance of the business is being artificially depressed to this extent)
Now onto the all-important issue of valuation:
Assuming the following key inputs for purposes of financial modelling of FY16 financials:
Revenue in core Lycopodium continues to fall, such that the ADP acquisition merely keeps Group revenues unchanged (ADP was generating $26m pa at the time LYL acquired it, so flat total Group Revenue for LYL even after ADP being on the books for the full FY16 financial period is certainly a conservative view, I’d argue).
LYL’s share of profits of the Pilbara JV (which is equity accounted, bear in mind) is $1.0m in the current half as its key project nears completion and goes to zero for FY16. For context, in DH14 alone, the comparable figure was $2.17m and for the full-year of FY14, it was $3.34m, and for FY13 it was $5.63m, so it has been a big contributor to LYL’s bottom-line, and I am assuming it is going to simply disappear. Again, prudently conservative, I think.
The ratio of “All People” Costs-to-Revenue (consistent metric in the trend series discussed earlier) falls to 84.5% in the current half (essentially unchanged from DH14), and to 83.0% in FY16. This compares to the company’s long-term average – excluding the last 3 quarters, which I’d argue are not representative of steady-state operating conditions – of 81.5%, so it too has an appropriate element of in-built conservativeness, I think.
The result is a business trading on 2.6x EV/EBITDA and 3.5x EV/EBIT.
It’s P/E is 15x, which might look more than generous for such a volatile, micro-cap stock, but remember that there is $37m of net cash sitting in the bank, so stripping this out, yields a P/E multiple of 4.4x.
Viewed yet another way, the market cap of LYL is today some $55m.
In 2006, when it was generating very similar levels of revenue, its market cap averaged closer to $70m over that year.
Moreover, today the company’s net cash position is $37m; in 2006 it averaged around $8m.
So LYL’s Enterprise Value today of $18m is 70% lower than it was when it was doing similar business in the past.
In fact, LYL’s Enterprise Value has never been lower during its entire listed history, than it is today.
Something will give.
Why is why I have been buying the stock since the interim result was released.
It’s not a stock in which one could – or should – ever have too much of one’s capital invested, and it’s notoriously difficult to acquire in reasonable volumes at any given time.
With little doubt, this is a “straw-hats-in-winter” investment proposition, and while I am generally drawn to straw hat investing, I don’t like to do so merely for the sake of it (my experience is that business cycle winters tend to last a lot longer than one initially expects, especially for inferior quality businesses).
I therefore like my straw hats to have something happening inside them which give them the chance to increase in intrinsic value should the winter be a persistent and long one (which might very well be the case in this instance).
And I do think that LYL does have some internal machinations going on that would lead to substantially improved financial performance at some stage, which in turn would translate into a market value for the company which is higher than its current $18m Enterprise Value.
Yes, I know it was the mother of all mining booms, but a company that generated $130m over the past decade, and paid almost $100m of that out as dividends, “feels” to me like substantially more valuable than just the $18m I’m effectively being asked to pay for it today.
(PS. It is not lost on me that on a measure of number of words in post relative to market value of st
ock, this must be an all-time high for HotCopper.)
(20min delay)