I have never been interested in mining services companies, or for that matter in resources generally. Mining services, and engineering contractors, have all the hallmark of poor businesses. They have large, powerful customers. They are having to navigate a feast/famine industry cycle. Their contracts are typically lumpy, difficult to price, and face stiff competition in a fairly undifferentiated market.
However, whatever we may say about the industry, the track record of MND cannot be denied. Whilst a rising tide floats all boats, it can also be very revealing about the prudence and "shareholder friendliness" of the management and enterprise. For whilst the tide was indeed lifting many, the resources feeding frenzy became, for many, an excuse for ego charged spending sprees, fuelled by testosterone and a wild belief that the party would never end. When the party did end, many balance sheets were bloated with valueless intangible "assets" and/or a whole lot of idle equipment destined for the sale yard. Tide or not, many left precious little for shareholders (indeed, it was the shareholders that footed the bill).
The same cannot be said about MND. In the 6 years ending in FY2015, MND brought nearly $270m of shareholders capital to the table (in book value at the start of the period, retained earnings over the period, and a modest amount of share capital acquired in the period). Over this period, the company generated about $675m in (underlying trading) after-tax earnings, spewed out about $640m in free-cashflow, and paid out about $590m in fully franked dividends. In dividends alone, the business delivered over 20% per annum on its shareholder funds (excluding the value of franking credits). But not only did it generously deliver income to shareholders, it grew the pie as well. In the period, the book value grew from about $120m to nearly $370m. And that's not because it became bloated with a whole bunch of goodwill and under-utilised assets. No, in fact the intangibles never amounted to as much as 2% of book value, over the period. In fact, excess cash has always featured very prominently and even in the depressed conditions of FY15, still represented nearly 60% of book value.
So the growth rate in book value, in the period, has been in the order of 20% per annum. Over 20% per annum in dividends delivered to shareholders (+ franking) and a pie growing at about 20% per annum as well! That's what I call delivering for shareholders.
Of course, many will say that a poor industry dynamics will eventually come home to roost, no matter how good the management or the track record. That is undoubtedly true. But when a business with a wonderful track record, is priced for extreme mediocrity, then I think it starts to become a no-brainer. I don't know how long it will take the industry economics to catch up with MND. But if I'm paying for mediocrity, then why do I need to know?
So why do I think MND is priced for mediocrity (or worse)?
After digesting the H1 FY16 results, it seems reasonable to assume that annual revenues from "maintenance & services"of about $640m can be sustained. If we further assume the fairly gloomy prognosis that revenues from "engineering & construction" will drop to about $530m by FY17, then we can assume revenues from FY17 of about $1170m. This assumption implies that "engineering & construction"revenues will have dropped by 70% from their peak in FY2013. Now as gloomy as this seems, I have no reason to believe that it is improbable. I do, however, believe that is it improbable that such depressed conditions will persist indefinitely.
So lets assume depressed revenues of $1170m persist indefinitely from FY17. If we further assume that gross margins drop to 7.5% (to account not only for depressed conditions, but also to account for the greater share of "maintenance & service" work), then we get gross profits from FY17 of $88m. For context, even under the depressed conditions between FY2000 and FY2004, MND was achieving a GM in the order of 9%.
A prolonged period of such depressed conditions can be expected to result in substantial cost reduction efforts. In fact, fixed costs (before D&A) have already dropped by 10% in FY2015 versus the peak values of FY2013. However, lets be ultra conservative and assume that fixed costs (before D&A) stay at the levels of FY2015 and FY2014 (about $25.5m). Finally, D&A expense is currently running at about $22m. However, this is not reflective of current capex expenditure, and almost certainly would not be consistent of expenditure should depressed conditions persist for an extended period. In fact capex was about $3m in FY2015 and about $4m in FT2014. If we assume maintenance capex from FY17 to $10m, then this will be consistent with the level that was being spent prior to FY2008. Then we can say that from FY2017, the business will effectively be achieving EBIT of about $52m (about 56c per share).
Finally, I shall assume that under depressed conditions, management will pay out 100% of the earnings as dividends. I think MND management has proven themselves able to be trusted on this front, especially when you consider that MND has typically paid, even during boom times, over 80% of earnings. But so that I don't rely too much on trust, I shall place no value on franking credits for dividends from FY17. This is a conservative assumption, on two counts. Firstly, the value of a high payout does not compensate for the value that growth will deliver, should MND find profitable ways to spend retained earnings (and they have the track record, and the high returns-on-capital, to match). The second reason I am being conservative here, is that the franking credits (which I am ignoring) have a greater value than reduced dividend should MND pay less than 100% of its earnings (as I am assuming), for the high pay-out rates MND typically applies.
So if I assume dividends (unfranked) from FY17 based on EBIT of 56c per share, then I can expect a dividend of about from FY17 of about 39c per share (ignoring the value of cash held by the business here, and remembering that there is essentially no debt).
So we have value from each of the following:
- Fully franked dividend for H1 FY16: 28c per share
- Fully franked dividend for H2 FY16: 22c per share (my estimate)
- Dividends from FY17: 39c per share (annually)
- $192m of net cash
Finally I shall assume that shareholders see non of the cash held by the business ($192m) for a full 5 years (as the company bunkers down, under depressed conditions). If I apply a discount rate, to each of the above 4 items, to get a value of about $6.00 per share (approximately the current share price), I need to apply a discount rate of about 9.5%. So, under such depressed conditions, and assuming no value from franking credits from FY17, with no upswing in the resources cycle ever. Ever. I am still going to get a return which is about 3 and a half times what I would get from an Australian government 10 year bond.
But we can go further. Even if I assume, that from FY17 earnings will go to zero for a full three years, and that the 39c annual dividend won't materialize until FY20, then I will still get a an annual return (ignoring franking credits from FY20) of nearly 8% on my investment. I will be getting over two and a half times what I would get from an Australian government 10 year bond.
Now unless there is something seriously wrong with my projections, and my analysis, how can this be anything but a fat pitch?
Mars
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