Persistentone,“I do understand the idea that they can revalue as...

Persistentone,

“I do understand the idea that they can revalue as they use free cash flow to pay down debt, but 10 years is a long time to do that and the story can change a lot, particularly if there is a serious recession.”


The beauty of any deleveraging thesis is exactly that you DON’T have to wait ten years for the intrinsic value to manifest itself.
It accrues every time the company’s balance sheet it published, i.e., every 6 months.


Let my illustrate by way of a simple working example, using the following salient financial parameters for TPI at the start of Year Zero:

Market Capitalisation = $1.4bn
Net Debt = $1.0bn
=> Enterprise Value = $2.4bn


And then in Year One, assume the company performs as follows:

EBITDA = $440m
Depreciation = ($170m)
EBIT = $270m
Interest = ($150m)
Pre-tax Profit = $120m
Tax = ($30m)
=> NPAT = $90m

OCF = EBITDA – (Interest + Tax) = $440m – ($150m + $30m) = $260m [rounded down to the nearest $10m]
Capex = ($140m)
Financing Commitments = ($20m)
=> FCF = $100m


Now assuming (and we’ll discuss the veracity of these assumptions later):

1. EBITDA is at cyclical lows and shows no growth from that depressed base
2. The stock holds its EV/EBITDA multiple (~5.5x, currently, for TPI) from one period to the next (i.e., EV is constant given EBITDA is assumed to be unchanged)
3. All the FCF is deployed exclusively to reducing debt


This means that Net Debt is reduced by $100m and the capital structure at the end of Year One, based on our assumption of constant EV, looks as follows:

Market Capitalisation = $1.5bn
Net Debt = $0.90bn
=> Enterprise Value = $2.4bn


Therefore, MARKET CAP, ceteris paribus and without any underlying improvement in the operating performance of the business, will have risen by some $100m (i.e., 7%) simply due to nothing other than the pure act of deleveraging.


Then, during Year Two, the company performs as follows:

EBITDA = $440m
Depreciation = ($170m)
EBIT = $270m
Interest = ($130m)...[lower debt and lower cost of debt due to improved position on the pricing matrix]
Pre-tax Profit = $140m
Tax = ($40m)
=> NPAT = $100m

OCF = EBITDA – (Interest + Tax) = $440m – ($130m + $40m) = $270m [rounded down to the nearest $10m]
Capex = ($140m)
Financing Commitments = ($20m)
=> FCF = $110m


This means that Net Debt is reduced by $110m and the capital structure at the end of Year One, based on our assumption of constant EV, looks as follows:

Market Capitalisation = $1.61bn
Net Debt = $0.79bn
=> Enterprise Value = $2.4bn

Therefore, MARKET CAP, ceteris paribus and without any underlying improvement in the operating performance of the business, will have risen by some $110m (i.e., 7%) simply due to nothing other than the pure act of deleveraging.

This rudimentary analysis can be recognised as SCENARIO 1 from my original post some days back.


Now, let’s get to some of the assumptions being made:

Firstly, the notion of flat EBITDA: TPI management are flagging $50m in cost reductions over the next two years.
And these are not “finger-in-the-sky” numbers; they are quantified by discrete projects that are being implemented (refer to page 6 of the presentation sides for the latest result).

Additionally, I think it is easy to overlook just how tough the DH of 2012 was fort his company, for a host of reasons, including the slump in construction activity on the east coast of Australia, as well as manufacturing in Victoria, and the implementation of landfill levy in NSW and the carbon tax that saw landfill volumes decline by a massive 24% in the half.

So it was a perfect storm for the waste management business, which I think means the $215m EBITDA result the group delivered was, in fact, highly credible for that reason.

So I think that an assumption of EBITDA remaining static is a brutally conservative one.

So, to your question about, “what happens if there is a recession?”
Well, I think they’ve just had their recession.

My view is that the earnings have definitely based.


Then , onto the issue of EV/EBITDA multiple being held constant at 5.5.

Clearly, this multiple is at a significant discount the market average EV multiple (which I sense is currently close to 8x), and probably reflects: 1) the high levels of debt (NIBD/EBITDA = 2.4x), and 2) the company’s chequered track record.

With little doubt, as the balance sheet de-gears, the multiple will re-rate upwards to reflect the reduced financial gearing.

So it is argued that scope for further de-rating of the multiple can be considered negligible (a further reason why I think the downside in the stock price is limited)


Finally, no discussion of TPI can be complete without dissection of the capital expenditure.

In the current half, capex was $89m, two-thirds of which was in relation to maintenance capex, and the remainder was for growth projects.

Management has indicated that for full-year 2013, capex will be around $200m, of which about $120m will be for “stay-in-business” purposes (which was the figure used in the exercise above), and $80m for growth projects.

That management are investing in organic growth, I think speaks volumes for the confidence in the outlook of the company.
(Of course, the growth capex further renders the notion of flat EBITDA highly improbable, but then the de-leveraging argument is reduced at the same time.)


So, to summarise my investment thesis for TPI:

The deleveraging effect, alone, delivering theoretical capital appreciation of 7% pa, presents me with a free option on any evidence of a real turnaround in the business, either due to cyclical recovery in earnings, but more like due to something that is far more bankable, namely an operational turnaround through active management of the company’s assets and its people, something that has not happened in the past.

The discussion above considered the trivial case of simply harvesting the surplus capital from a static earnings base in order to reduce debt; however, in reality, what I think will happen over the next two years will be a combination of cost reductions driving improved cash flows, and growth capex driving increased underlying earnings, and asset sales driving further debt reduction.

At valuation metrics of just 5.5x EV/EBITDA, market expectations for any success are clearly very low.

Management need only to get it half-right, and the share price will respond handsomely.

And based on what I saw in this latest result, the underlying business indicators are travelling significantly better than just “half-right”.