scenario analysis highlights return potential

Some of my best investments over time have been “turnaround” situations. i.e., companies that got themselves into trouble by doing strategically silly things, or where the business landscape has suddenly changed, requiring the company to make some drastic changes to the way it does business.

Examples of these sorts of turnaround situations where I have had investment success in the past are SKE, SDI, MMS, BRG and WES.

My experience has been that investing in turnaround situations always tends to end up being more complex affairs, and they take longer, than one expects.

With little doubt, as an investment prospect TPI must be treated as a turnaround situation.

Like so many companies, during the halcyon days leading up to the GFC, the then-TPI management team and board went on a wild acquisition spree, believing that economic growth would continue to be robust and support the valuations paid at the time for acquired businesses.

The company spent around $2.8m in the period between 2006 and 2009 on acquisitions, including the huge $1.25bn acquisition of Cleanaway from private equity group KKR.

The result was NIBD that went from $130m in 2006 (corresponding to NIBD/EBITDA of 1.8x) to $2.4bn in 2009 (NIBD/EBITDA ended up being a crippling 6x that year).

With the expected earnings from the ill-considered acquisitions not coming through to support the debt, the company faced the prospect of administration, but was clutches of the administrators by over $1bn of equity raisings in ($70m in 2009, $800m in 2010, and $2680m in 2012)

Which brings us to where we find ourselves today:

TPI is a company generating EBITDA of some $430m to $440m expected for FY13 (which will be the first year it is up since the debt crisis for the business which peaked in 2009...so it looks like earnings have finally found a base), with NIBD of around $1.0bn.


What I like about TPI is that, while most turnaround situations are complex, require tight management focus, TPI’s capital generation characteristics mean that the company has to demonstrate very little improvement in operating earnings, and sheer financial deleveraging will naturally drive explosive growth in the bottom line.

In evaluating TPI’s investment prospects, I considered 5 scenarios, looking out over the next few years:

(Note: a spreadsheet can be made available for those who are interested in seeing the mechanics of financial deleveraging first hand. It might also help to follow the discussion below):


SCENARIO 1: BASECASE - ONGOING RECESSIONARY EARNINGS WITH NO RE-RERATING OF VALUATION MULTIPLE
• In this case, recessionary level earnings are assumed to persist for the foreseeable future.
• In other words, no cyclical recovery occurs from the current slump in construction demolition sector.
• i.e. EBITDA growth is held at zero for the next two years.
• Despite this sober outlook, the resulting FCF causes NIBD to reduce to $900m by the end of FY14, down by almost $500m from FY11’s $1.4bn.
• This lower of level of NIBD, plus lower borrowing costs, reduces the interest expense to $90m, down by around $80m from FY12’s $170m level
• And because the interest bill today is such a dominant feature of the P&L - being almost double Pre-Tax Profit and a significant two-thirds of EBIT, as it reduces - the impact on the bottom line becomes amplified dramatically.
• In this case, by just the deleveraging effect alone, assuming no EBITDA growth at all, NPAT will almost DOUBLE between FY12 and FY14.
• In CAGR terms, this equates to plus-30%pa NPAT growth
• And, in the EV calculation, as NIBD is reduced the market cap will rise to take its place (since we assume the EV/EBITDA multiple remains unchanged going forward at the unlikely and improbable undemanding level of 5.5x)
• The result is 15% total capital appreciation over the next two years, or 7%pa capital appreciation.


SCENARIO 2: MODEST RECOVERY IN EBITDA (NO RE-RATING OF VALUATION MULTIPLE)
• In this case, modest EBITDA growth of 2%pa is modelled.
• In CAGR terms, this equates to around 40%pa NPAT growth over the next two years.
• Again, holding the EV/EBITDA multiple constant at the current 5.5x EV/EBITDA level, points to 23% total capital appreciation over the next two years (11%pa)


SCENARIO 3: MODEST RECOVERY IN EBITDA, BUT WITH GRADUAL RE-RATING OF VALUATION MULTIPLE
• In this case, EBITDA growth of 2%pa is modelled again, the same as Scenario 2.
• But the difference in this scenario is that the assumed EV/EBITDA multiple will rise by 0.5x every year.
• This would likely occur as the market acknowledges the falling financial risk, as the debt falls and interest coverage ratios rise.
• For context, EBITDA-to-Net Interest will rise from FY12’s 2.5x, to 3.0x in FY13, 4.7x in FY14 and 5.4x in FY15.
• Precedent shows that this sort of improvement would be accompanied by a favourable re-rating of the stock.
• In CAGR terms, this scenario is the same in earnings growth terms, i.e., around 40%pa NPAT average growth for FY13 and FY14.
• But with the EV/EBITDA multiple rising to a level of 6.5x EV/EBITDA by FY14, this points to around 58% total capital appreciation (25%pa).


SCENARIO 4: CYCLICAL RECOVERY IN EBITDAACCOMPANIED BY COMMENSURATELY GENEROUS RE-RATING
• This is the undeniable Bull Case
• In this case, EBITDA growth of 2%pa is modelled again, the same as Scenario 2, but with an acceleration to 7% growth in FY14.
• This is to reflect what would happen in a cyclical recovery for TPI’s business.
• The other difference in this scenario is that the assumed EV/EBITDA multiple will rise by 1.0x every year.
• This would likely occur as the market acknowledges the lower financial risk, as well as “buys” the cyclical recovery.
• In CAGR terms, this scenario results in almost 50%pa NPAT average growth for FY13 and FY14
• And with the EV/EBITDA multiple rising to a level of 7.5x EV/EBITDA by FY14, this points to excess of 100% total capital appreciation (44%pa).
• Note that 7.5x is not a overly hairy-chested assumption to make: EnviroWaste NZ was recently acquired for NZ$500m by Cheung Kong Infrastructure Group on an EV/ EBITDA transaction multiple of 10x


Like all exercises of this nature, it is intended to be more indicative than prescriptive.

But what I like about the conclusions it makes is that without TPI management doing anything dramatically positive with the business, and without the cycle turning aggressively favourable for the company, the simple phenomenon of financial deleveraging will drive bottom-line profits aggressively.

[Note that this dynamic is not universal to all companies; for it to occur requires the company in question to have the requisite FREE CASH FLOW generation characteristics (i.e., Operating Cash Flow needs to be well in excess of Capex), and it requires the board to adopt the mandate of using the FCF to retire debt, and NOT re-embark on acquisition sprees.]

There is clearly a significant amount of leverage in this company – both of an operating and a financial nature.

That means that there are risks, too, because leverage works the other way, too.

But I believe the board and executive management know that their brief is a simple one:
1. Harvest the Surplus Capital
2. Pay Down the Debt and
3. Let the Bottom Line Fly

It’s really a cushy gig.


I expect the upcoming result will be soft given the slow grind in some of the economic sectors serviced by TPI in the second half of the year.

My hope is that the stock is heavily sold on the result, as that will provide an excellent buying opportunity for the story that will continue to unfold over the next 18 months.



Cam


PS. As I indicated, it would probably easier to follow the scenarios discussed above with a copy of the spreadsheet open at the same time. So if anyone would like a copy of it I am happy to forward to e-mail addresses supplied