some devil's advocacy

BKN reminds me a lot of BLY as a business model, it has a high fixed-cost structure, it struggles to generate surplus capital, and it has limited pricing power...indeed its product are even more commoditised than BLY’s (essentially, BKN manufactures low-tech, heavy-engineering components, a business which really has limited global barriers to entry).

And the first thing that happens on mine sites when things tighten is that head office "confiscates" the cheque book from the mine manager, and so the mine workshop foreman sends his mechanics into the scrap yard to strip parts off parked equipment. [I know this first hand].

And it’s not just from the consumable side that BKN’s business is likely to be affected.

Remember that BKN manufactures not only consumable parts for existing units in production, but also for new equipment being manufactured.

With that in mind, I draw attention to the numerous earthmoving equipment manufacturers around the world who have been reporting in recent months significant falls in orders for new equipment, as cited by the likes of Komatsu, Caterpillar and Liebherr.

So, without having a big financial model on the company to confirm it, 30% NPAT growth forecast for BKN in FY13 (which is what broker consensus forecasts are suggesting currently) appears to the stuff of either dreams or incompetence (both, probably).

I know the Outlook statement issued by the company with the FY12 full-year result spoke of “record order books” and “defensible margins” but as we have seen many times in the past, order books are full until suddenly they are not.

As we saw for BLY, things can turn sour very quickly, and suddenly manufacturing facilities are forced to operate at less than optimal capacity utilisation, with the subsequent erosion of margins that had been slated to be “defensible” when things were running at full tilt.

It warrants pointing out, I think, that BKN's EBIT margins at the start of the commodity boom in 2006 were a little over 12%. Last year they reached 16.7%.

Bizarrely, analysts are not expecting any mean reversion in BKN's EBIT margin as we go beyond the boom peak: For FY13 the EBIT margin is forecast to be almost 100bp higher(!) than FY12's boom margin, which I think reflects either a fundamental misunderstanding of the structure of BKN's P&L, or it is a bizarre denial that the resources cycle has moved beyond its peak.

Also, BKN has too much debt to my way of thinking (NIBD-to-EBITDA over 2x) for what it is as a business, and given where we are in its business cycle.

This is a business which – during the mother of all booms in its business - has not been able to generate any free cash flow.

Quite the opposite, in fact; it has over the past four years since the GFC:

• generated ~$400m in OCF,
• ploughed ~$300m of that back into the business to keep the foundries going (or whatever),
• and has spent a further ~$450m on making classic, top-of-the-cycle acquisitions

• To balance the books, it has tapped shareholders for $400m over that time.

BKN management has issued new equity in 3 years out of the last 4. They skipped FY12, so they could be due to come to the market again.

So, in summary, I think the stock is cum-downgrade and possibly even cum-raising.

I think there’s a significant risk that BKN is pregnant with its BLY moment.

I don’t mean any malice or churlishness with this post; I’m simply trying to provide some grist to the mill (pun needing pardoning) of the debate surrounding BKN, as I sense a continued degree of complacency about the possible challenges facing this company.

Hey, the stock might indeed continue with its recovery bounce, I wouldn't know, but I do think the risks are rising with every new leading indicator datapoint that I see.

Prudent Investing

Cam