Ann: Contract Awards, page-2

Interesting little company this; right in the sweet spot of very strong infrastructure cycle, strong commercial development market, and and a recovery in the resources sector, yet it's share price is plumbing 3-year lows.

Company has a market cap of $110m, with a net cash balance of exactly half of its market cap, so an EV of just $55m.

Revenue expectations for FY2019 are for $400m ($181m recorded in DH2018) and assuming modest EBITDA margins of 5%[*] - for context, FY2018's EBITDA margin was 5.2%, derived from $350m in Revenue and in DH2018 the EBITDA margin was 5.0% - that implies EBTIDA currently running at around $20m.  

So, an EV/EBITDA multiple of some 2.7x.

And while for acutely cyclical businesses such as this one, valuation multiples should naturally compress at the top of the cycle, it's not as if the market can possibly be pricing in any sharp cyclical contraction in earnings any time soon given that the company can see a further $2.5bn pipeline of work, including the $900m of work for which the company already submitted tenders.

So less than 3x EV/EBITDA for a business that is enjoying healthy industry tailwinds, and which looks to be reasonably well-managed without its managers showing any propensity to do anything dumb with the shareholders' capital.

Which looks too good to be true, but that's because there are a few caveats that need to be drawn:  

Firstly, as the chart below shows, earnings for this company are notoriously volatile and, accordingly, accurately forecasting future profits is impossible:



(Hence, ignore the blue columns, representing notional forecasts for the next 3 half-years; those forecasts are largely meaningless and should not be relied upon for any investing decision.)


Secondly, the problem with the business model is that the work done by SXE only takes place right at the tail end of major projects (i.e., when the electrics, instrumentation and switches get hooked up); this means that SXE is not in control of the timing of work and is dependent on factors outside of its control, which means it needs to maintain an element of redundancy in its cost base at all times.

Related to this point, the company's $56m Net Cash position needs to be put in context.

While that cash balance is fully owned by SXE shareholders, not all of it is available to be distributed to shareholders at any given point in time.

This is because of the high level of working capital intensity of the business, especially during the upswing phases of SXE's business cycle.  Trough-to-peak, Work in Progress (WiP)-to-Sales ranges between 3% and 15% which - when Revenue goes from less than $150m at the bottom of the cycle, to over $400m at the top of the cycle - works out to a Work-in-Progress requirement of less than $10m at the trough, to in excess of $50m in the cycle upswing:



That significant investment in WiP in recent periods has resulted in the the company generating no Free Cash Flow over the past two-and-a-half years.

Of course, the upside to this is that, as the WiP unwinds over the course of the maturing cycle, the company is sure to report improved free cash flows in coming financial periods.

But be cautioned, we won't see anywhere like the full ~$50m of WiP increase over the past few years being freed up in the next few years because to a degree that WiP increase was partly funded by a $30m increase in Payables.  Also, there was a $28m Deferred Revenue balance at 31 Dec 2018, which is currently being serviced.

But the point being made in this exercise is that there are some very significant things that impact the cash flows of the business at various stages of the business cycle, about which I think it is important to be aware.

Conclusion
This can never be a slam-dunk investment, given the sheer nature of the company.
But it looks like it is being priced for some sort of earnings calamity which I just can't see happening given the prospective state of demand for their services.



[*]  Yes, margins are wafer-thin, which means very high levels of operating leverage in the P&L (bad during downturns, but helpful during cyclical upswings). But offsetting this operating leverage, to some extent, is that the company's Revenue model means it is not exposed to EPC-type contract pricing risk.  Also, it is a capital-light business, so the company earns its cost of capital over the course of a full business cycle, although ROC is highly variable, ranging from negative during the cycle slump, and in the high-teens/low-20% region during the boom times.