Buying

This is a mediocre business which, like most in its space, significantly overcapitalised during the boom years such that shareholders paid the price when the downturn arrived (the price paid was dilutive equity raises to pay back excessive debt accumulation). That said, i think it is now a mediocre business which is priced without recognition that it comes with: 1) a clean balance sheet, 2) a management team finally on board with the concept of returning capital to shareholders (as opposed to always asking for more), and 3) potential for some gentle cyclical earnings improvement.

As far as earnings go, I think about it in terms of the underlying GCS business, then acquisitions, and i think about what the business could do in FY18. I think the underlying GCS business (excluding SmartScaff, which was sold) will do about $29-$30m EBITDA this year, Podium Glaze appears to be a ~$4m p.a. EBITDA business (based on $70m revenue * 10% EBITDA margin * 50% GCS stake), and Summit is a ~$5m p.a. EBITDA business. So, with no improvement from GCS' core business (and it's currently sitting on cyclically low point EBITDA margins - see below), i get to a pro forma FY18 EBITDA of around $39-40m. GCS will spend about $6-7m in capex (consistent with expenditure from FY14-FY16), which is in line with their new annual D&A charge of ~$5-6m, so i get FY18 EBIT of ~$33m, and assume 100% cash conversion (consistent with past results - they typically convert all earnings to cash over the cycle). Pro forma market cap is (200.2m shares + ~9m shares issued to Summit = 209m shares) * $0.58 = $121m; pro forma net cash is ($14m - $13m Summit upfront cash and earn-out consideration) = $1m; so pro forma EV is $120m. So, FY18 pro forma cash EBIT of ~$33m provides a 27.5% yield on enterprise value. Assuming ~$2m interest, provides FY18 EBT of $31m, or NPAT ~$22m, which is an ~18% yield to equity.

While that FY18 $22m free cash to equity number sounds great, GCS has to repay ~$10.6m in hire purchase liabilities, according to note 31(c) of the 2016 annual report. Assuming they simply make that payment and then pay the rest to equity, that would leave ~$11m to be distributed, which would be a ~9% pro forma FY18 dividend yield. I suspect the cash left over to equity in FY19 will be significantly better, because by then the last vestiges of the boom years (2010-2013) hire purchase acquisitions will have unwound - we don't know exactly how much they have to repay in FY19, but from FY19-FY21 there's a total of $14m left to be repaid, so that leaves GCS in a good position to throw quite a bit of cash back to shareholders (either via buybacks, or dividends). And when the cash starts coming back to shareholders (either via dividends or buybacks, the latter of which i think is the better method currently given where the stock is trading), i suspect the stock will start re-rating from its current pro forma 18% equity yield / 27.5% EBIT yield.

I also think there's some gentle cyclical upside to the margins they're making, particularly in the commercial division, from two areas. The first is that they blew up their operating lease liabilities (in addition to their finance purchase liabilities) in the boom - annual operating lease expenditure went from ~$2.5m in FY11, to $9.2m in FY14, and is now back to $6m and heading further down - if that continues to wind down (as it has been since FY14) all the way back to pre-boom levels, that's $2-3m in operating lease expenditure saved. The second is that their PPE at-cost turnover is at cyclically low levels - prior to 2014 they turned over their rental equipment between 1-1.6x on an at-cost basis, whereas in FY16 this was <1x. Even a gentle improvement in PPE turnover should see margins improve, and every 1% EBITDA margin improvement just in their commercial division is worth ~$1.3m p.a. given ~$130m segment revenue. For some sense of history, their commercial division did $132m EBITDA on $456m revenue from FY09-FY13, or a 29% EBITDA margin - today, that same commercial division is sitting on a ~16% EBITDA margin. I think the days of high 20's EBITDA margins went long ago with the end of the mining boom, but i suspect (hope?) there's some gentle upside to the ~16% present day EBITDA margin assuming they can win a few decent contracts to drive volume through the excess of PPE they acquired in the boom up until the end of FY13.

While i don't normally pay too much attention to institutional shareholders, i see that Lanyon has recently bought in around current prices and now sits at ~15% of total shares. Lanyon has good runs on the board in terms of its track record in value situations such as these - they've significantly and consistently outperformed the market over the last 8 years, despite holding a lot of cash - and i suspect they see a similar dynamic at play with GCS as they did with other of their holdings, such as PMP.

I'd be particularly interested to hear whether others have thoughts on the prospect of some EBITDA margin bounce-back potential in the commercial division - is that now just a permanent 15% margin business (i.e. were their 2009-2013 ~30% EBITDA margin years just a complete statistical outlier that came about because of the mining boom?), or does some potential exist for a gentle improvement on today's 15% margin (maybe to, say, 20%, still a long way behind the 30% glory days)? It seems like their commercial division hollowed out its cost base from ~$96m in FY12 to ~$70m in FY15 on the downturn, then they suddenly grew this division's cost base to a new record high of $99m in FY16 (i.e. cost base went up $29m in one year to support only $34m additional revenue relative to FY15, so there was no margin benefit given 34/29 = ~15%)? Also appears as though most of that growth in their cost base from FY15 to FY16 was in raw materials / consumables, which is more volatile as % of revenue from year to year than other cost categories - is there something in particular within GCS that's potentially driving this?