Ocker, When we discuss MCP's debt, I hope we are being...

Ocker,

When we discuss MCP's debt, I hope we are being consistent. There are a couple of idiosyncrasies with the way MCP's working capital ebbs and flows which obviously have cash flow - and hence, balance sheet - implications at various stages of MCP's financial year.

The first thing to note is that MCP's working capital requirements peak in the December half of each year. This stands to reason because MCP itself stocks up and starts to fill customer orders ahead of the December consumer demand period. So, working capital levels @ 31 December of each year are typically 10% higher than June balance dates. Accordingly, so too are Net Debt levels 10% to 15% higher at December 31 close-offs of the books than 30 June. I can't be sure, but I trust your assessment of average net debt accounts for this seasonality, since this information is publicly available.

However, what isn't publicly evident, I don't believe, is that the ABSOLUTE peak in MCP's working capital funding requirement does not occur on 30 December of each year. Instead the real peak commences about now and lasts for the next 2 or 3 months. This means that the snapshots we see when balance sheets are struck on 31 Dec and 30 June of each year are exactly that: snapshots. But they fail to dimension accurately enough what is happening to MCP's debt continuum over the entire financial year.

The reason I know this debt bulge occurs around September/October is because while I was a fund manager it was confirmed to me over a number of years by the company's financial officer. (What prompted this discussion in the first instance was that I could never reconcile interest expense incurred in the Dec half with a plain linear average of net debt levels at 31 December and 30 June. By way of demonstration, the implied interest rate being charged in each half (derived by dividing Annualised Cash Flow Interest Expense by Average Net Debt [DH+JH]/2) oscillates as follows:
JH01: 6.6%
DH01: 8.7%
JH02: 7.6%
DH02: 8.7%
JH03: 6.5%
DH03: 11.7%
JH04: 6.2%
DH04: 6.5%
JH05: 8.4%
DH05: 10.2%
JH06: 6.2%
DH06: 10.0%
JH07: 9.4%
DH07: 10.2%
JH08: 9.3%
DH08: 9.0%
JH09: 8.2%
DH09: 9.2%

So what we've got here is a situation of debt seasonality, but with the true intensity of that seasonality being hidden from view: Dec 31 Net Debt is typically 10% higher than June 30 Net Debt, but Dec HALF Net Interest is typically 25% higher than June HALF Net Interest.

So, to conclude, for MCP, average NIBD (monthly-weighted) is around 15% higher than the six-monthly NIBD average, as we see it reported. I had a read of some of my old file notes (circa May 2007) and they make reference to MCP maintaining a $90m working capital facility, materially higher than the highest working capital levels reported in the preceding years, further confirming that true average debt for MCP is somewhat greater than that derived by simply averaging DH and JH reported debt levels:
MCP Working Cap (as opposed to $90m facility):
DH03: $56.8m
JH04: $53.2m
DH04: $74.0m
JH05: $64.0m
DH05: $61.0m
JH06: $51.4m
DH06: $62.8m
JH07: $58.7m
DH07: $62.7m

Please don't consider me to be overly petty here, but this distinction is to me not a trivial matter given where the company is on its evolutionary timeline, and more crucially, how I believe it should be valued.

Put another way, MCP has never been in a more flexible financial position than it is today and will increasingly become over coming reporting periods. It's solvency metrics have never looked as good, viz.:
NIBD/Annualised EBITDA:
DH00: 1.9
JH01: 3.6
DH01: 2.2
JH02: 2.7
DH02: 1.8
JH03: 1.9
DH03: 2.0
JH04: 2.0
DH04: 2.4
JH05: 5.6
DH05: 3.6
JH06: 3.7
DH06: 2.3
JH07: 2.5
DH07: 1.8
JH08: 2.2
DH08: 2.3
JH09: 3.4
DH09: 1.5
JH10: 1.6
DH10: 1.1 (My Forecast)
JH11: 1.0 (F)
DH11: 0.8 (F)
JH12: 0.7 (F)

EBITDA/Net Interest:
DH00: 6.3
JH01: 4.1
DH01: 6.0
JH02: 5.3
DH02: 3.6
JH03: 2.8
DH03: 5.0
JH04: 5.6
DH04: 6.3
JH05: 2.2
DH05: 3.2
JH06: 3.0
DH06: 4.1
JH07: 3.8
DH07: 5.9
JH08: 4.7
DH08: 5.2
JH09: 3.3
DH09: 6.4
JH10: 6.1
DH10: 8.7 (My Forecast)
JH11: 9.0 (F)
DH11: 11.4 (F)
JH12: 11.2 (F)

Clearly, during the economically halcyon days of the mid-2000's MCP, like many other corporations blissfully unaware of the pending GFC, became a bit aggressive on the debt front, with NIBD well over three times EBITDA and EBITDA covering Net Interest by a mere 3 times.

On my forecasts, and allowing for the imprecision inherent in spreadsheet assumptions, MCP's NIBD will fall below EBITDA, and EBITDA/NI will reach double digits, sometime in the next 12-18 months. My contention is that, because these easy solvency metrics present scope for capital management options, this makes MCP a totally different investment proposition than when the company was financially straight-jacketed.

And another thing, and I never invest specifically for takeover potential, nor on thematic lines, but if you asked me what the biggest theme will be for the equity market in the coming year or two, then I'll say it will be that we are on the cusp of a period of significant merger and acquisition activity. Here's why:
1. This past reporting season (and even the one before that, to a large degree) was characterised in my mind by a very strong and consistent thread, namely very good profit growth performance, but (and its a very important "BUT") profit growth totally unassisted by any top line growth. In other words, revenue gains have been hard to come by, but management teams have been delivering bottom-line growth by driving up margins through cost-reductions. Well, Corporate Inc. has been squeezing the cost lemon since the onset of the GFC around 2 years ago. My belief is that the cost lemon is approaching the point of having little remaining juice. The next logical step for the corporate entity - whose raison dtre, remember, is to grow - will be to acquire other, undervalued entities. This is not at all novel or creative thinking. There are many precedents for it occurring when the world emerges from economic downturns. The only difference this time, is that credit will continue to remain on ration from the major commercial banks, so predator companies will either be required to have pristine balance sheets, or will have access to equity capital, in order to undertake takeovers. Or, and this is important in the context of MCP's prospective balance sheet, acquisitions will need to be self-funding.
2. Corporate balance sheets are in healthy shape:
Following the $150bn of equity capital raised in the Australian market since the GCF, as well as a tight control over capital expenditure and operating costs over the past 2 years, this has left ASX200 stocks with NIBD/EBITDA which is the lowest it has been for 7 years.
3. Equities are not expensive.
We can all identify many stocks trading at steep discounts to historical valuation metrics. While I argue that this is largely appropriate in the wake, and indeed the lingering aftershocks, of the GFG, the equity risk premium will not stay high forever. Every day, week and month that global economic news appears to be less toxic (even if it isnt exactly rosy) boardroom confidence will edge upwards until the point that the realisation is reached that the low-hanging cost reduction fruit has mostly been picked. When that happens, M&A activity will resume, just like it does every other economic and equity market cycle.
4. Barbarians Approaching the Gate:
Private equity (PE) funds have near-record levels of cash holdings, and we see numerous media reports of PE funds gearing up to resume doing what they do. Like company executives, they have probably just been waiting for the GFC reverberations to die down.

I am making no claim to an investment in MCP or any other company on the basis of takeover potential, but I tend to think like PE funds in terms of investments being able to fund themselves. And I am quite happy that my purchase of MCP in recent weeks will be more than a self-funding acquisition for me.

[Hey, maybe I should approach my bankers for a $240m loan to buy the remaining MCP shares I dont currently own.]

Prudent Investing

Cameron