This is a question that I previously raised. Many people on this...

This is a question that I previously raised. Many people on this forum thought that MES could possibly use 6.5M this year and probably another 6.5M next year, and borrow another 12M to fund a 25M project(P4). Well I have a different opinion.

First of all, I want to point out that instead of looking at profit figures, we should focus on the free cash flows, because funding is in essence a cash flow problem, I've seen too many great companies with a mouthful profits died on funding shortages. We knew that MES in on the growth phase so I don't expect positive FCFs yoy. Now let's dig into it for MES. See below: (numbers quoted in A$ millions, rounded)

In FY2007, IPO year: the firm had operational cf= -3.8, investing cf= -5.7, FCF=-9.5, after raising 20 from IPO gearing=7%. Standing on 32 of cash.

In FY2008, invested 26 in new plant and equipment: the firm had an operational cf=13(note: due to timing issue some payments to suppliers are not included in this FY, so the operational cf=13 is over-stated), investing cf= -25, FCF=-12, gearing=44% as the result of MES increasing its debt proportion by 10 to fill the gap. Yearend cash standing on 42.

In FY2009, feeling the impact of GFC: operational cf=-16, investing cf=-2, FCF=-18, gearing increased to 52% as MES increased its net debt by another 8. Yearend cash standing on 24, decreased 18 which equals to the FCF short fall this year. Please note that the more debt a firm taking on, the more volatile would its FCF be (as it needs to pay more to creditors every year) and hence more venerable to bankruptcy on financial distress.

In FY2010 half way, operational cf=0.4, investing cf=-0.9, FCF=-0.5. MES took on another 13 net borrowings. But MES is far from the harvest season, the firm still hasn??t got time to earn enough cash profits to cover its recent expansionary outlay. With gearing edging up at high levels, we cannot expect MES to fund its P4 by much debt (as it would be too too too aggressive), so the hope is on its 2010 and 2011 FCFs. Let??s have a look.

Now assume under current conditions, with little investment outlay and handsome earnings, MES can produce yearly FCF=6 for two years in a row. Hence by 2012 MES would have saved 12, adding to its 2009 yearend cash balance of 24, giving MES 36. This is too tight for 25 capital ex. Because the firm still needs to fulfil its obligation to creditors, based on 130 outstanding debt in 2010 and 5% interest cost I suspect the interest cost=7, leaving 4 on hand. Since the company still needs to maintain a cash level for general operation, I don??t think 4 is adequate.

My conclusion is that the company is expanding too aggressively, it has no money to facilitate phase 4 expansion, unless it can raise more debt which is out of my comfort zone; or secure another capital raising down the track (with the hope that the SP will recover fully by 2011-2012).

The risk is that China will be forced to hike interest rate aggressively over the course of 2011/12 to the extent that aggregate demand is cooled down, which posts some downside risks for MES future EPS estimates.