Corporate,This in response to your enquiry from a few days back...

Corporate,

This in response to your enquiry from a few days back on the BKL forum.

I'm afraid that, like most mining service businesses these days, I'm not a fan of SDM as an investment opportunity.

Don't get me wrong, it's not that I don't like the people involved, nor do I have any problem with any of of the internal aspects of the company.

As an engineer by training myself, I generally like engineers. I think engineers are generally good, honest, hard-working folk with little penchant for doing anything reckless. I can identify with their innate conservativeness.

The issue that I have with SDM, and companies like it in this space, is the external vulnerabilities.

When you one day open your doors for business and you see a queue of customers as far as the eye can see, and then the next day you open the doors and there's no one there, then that's really a challenging investment proposition no matter how good the product or service is that is being peddled.

As case in point, on the back of the coal boom over the past year or two company has been over-earning by a long way, in my opinion.

For context, in 2007 before the world of coal went nuts, SDM generated some $26m in EBITDA on Revenues of $175m.

Fast forward to peak of the cycle, viz. FY2012, and the company reported $69m in EBITDA on $590m of Revenues. Crudely, that's basically a near-trebling of the P&L in just five years (via an exponential path, with sequential EBITDAs of $26m, $42m, $51m, $44m, $58m, and $69m).

The thing that worries me about this trajectory is that, no matter what SDM management say (and remember, I like them...you don't get awarded the Prime Minister's Exporter of the Year Award for being knuckleheads) about service diversity into other minerals, this company is still very much as one-trick pony: viz., the design, construction and operation of Coal Handling and Preparation Plants.

They may well be the world's leader at this, but it is still an acutely narrow service positioning. And when things go ballistic, al la 2011 and 2012, you get to reap excess financial returns.

Trouble is, you have to pay the piper when things turn down again. And as is clearly evident, things have, or are, turning down.

I see consensus forecasts for FY13 and FY14 EBITDA of some $60m.

And on that basis, the stock does look cheap, at EV/EBITDA of 2.5x and P/E of 7x.

[I note that almost half the market capitalisation of the company is represented by cash.]

Problem is, I have no faith in the those forecasts.

Precedent tells me EBITDA could just as well end up being $50m, or $40m, for that matter.

This is a people business, and when the work runs out the people don't, and then the fixed costs chomp into the margins before you can say "coal is a deep cyclical commodity".

And I have observed over many years that, while forecasting commodity prices is not done very well by people who are eminently qualified to do so, for coal the mis-forecasting is an order of magnitude worse, with analysts and specialists invariably too optimistic.

If I may be so brazen as to assume the role of novice forecaster myself, then I'll proffer that this particular coal cycle downturn presents us with the prospects of a particularly harsh hangover, given the supply side surge that was induced by the last few "hallelujah" years, coupled with what looks like being an increasing demand side shock unfolding (maybe? possibly?) in the form of the breakthroughs in shale gas technology, which has affected the coal industry in the US, and which it seems other major global energy consuming nations are now endorsing, including China, hitherto that big thermal coal sponge.

A personal anecdote I can share: an associate of mine runs a "mini-SDM", based in Newcastle, employing maybe 30 design engineers, focused also on CHPPs all around Australia, but also globally. We chatted about a month ago. The tone of the conversation was very negative. Basically, things had turned down so quickly for these guys that they engineers that they had struggled to recruit as little as nine months ago when they had an overload of work coming down the pipe, were now idling with no work ot do, and were on the cusp of being let go.

Sorry, I hate to be the harbinger of negative news.
I am merely responding to a solicited request for an opinion.

Cam