Monthly Archives: November 2013

Valuation of highly leveraged/distressed equities

Recently two articles were published on Seeking Alpha about Dex Media (DXM), one arguing that the stock could be a 30x bagger and one arguing that it will be a zero. Seeing both the bull and bear thesis for a stock is in my opinion always interesting, especially when there is a big divergence between the two viewpoints. If someone is wrong there might be an opportunity to make money! But in this case I think both authors are making a fundamental valuation mistake.

Dex Media is extremely leveraged: the market value of the equity is just $130 million while the company has $3 billion in debt with a market value of $2.1 billion. Shorts often use this statistic as an argument that the equity should be a zero, and the author of the Dex Media short case isn’t an exception:

But the intelligent investor needs to temper expectations of a multi-bagger opportunity in the equity with the plain fact that the debtors are willing to sell the debt at a discount to par, implying that the equity has no value whatsoever.

I would argue that this is not the right perspective. The equity is at this moment effectively an out of the money call option: there is zero intrinsic value, but it could still have plenty of extrinsic value. The debt doesn’t reach maturity until late 2016/early 2017, so what you have is an option with two years till expiry. The question you should be asking is: “what is the probability that the fundamentals change between now and then in such a way that the market value of the company changes from today’s $2.2 billion to >$3 billion?”. To be clear: I have no idea what the answer to that question is! But what I do know is that you can’t present a good argument for a long or short case without trying to answer this question.

Dex Media is one of the many dying yellow pages businesses worldwide that is trying to move online. At the moment the legacy business is quickly deteriorating while the online business isn’t great either, but I would argue that there is probably a large amount of fundamental uncertainty on how this company will look like in one or two years time. It’s not impossible that they can slow down the decline in the legacy businesses, or turn around the internet business. Maybe there is a ~10 percent probability that Dex Media is in two years time a company with a >$4 billion enterprise value. In that case both the equity and the debt could be priced correctly, even though the debt is currently trading at a big discount to par.

Options do have value when they are not in the money. The big – and in this case unanswered – question is how much value?


No position in DXM

Two year blogging anniversary!

Just two years ago the first post on this blog saw the light of day, and when I see new and promising blogs disappearing all around me that seems to be an accomplishment in itself. It’s not something I fully understand since starting this blog might have been my best investment decision so far. The process of writing down a stock thesis in a coherent story forces me to think about all angles, and making it public is just a small additional step with big benefits thanks to you, my readers! It creates accountability, and I have received plenty of valuable feedback, new insights and promising idea’s. Cheers to my readers!


Emeco Holdings: a net-net in disguise

Emeco describes itself as worlds largest independent mining equipment rental business. They get the majority of their revenue from Australia, with the remainder coming from Canada, Indonesia and Chile. The business is at the moment struggling because the demand for their equipment has plummeted. In FY2013 utilisation dropped from 80% at the beginning of the year to 50% at the end of the year, and it’s currently down to just 43%. Yesterday the company provided some guidance on expected results for 2014, and the picture isn’t pretty: EBITDA will shrink from A$175 million to A$90-105 million while operating profit, before any potential impairment losses, will be between negative A$10-17 million. Throw some financial leverage in the mix and it isn’t hard to understand why Emeco isn’t loved right now. Notice the difference between market cap and enterprise value:

Last price (Nov 19, 2013): 0.24 AUD
Shares outstanding: 599,675,707
Market cap: 143.9M AUD
EV (mrq): 559.3M AUD
P/B (mrq): 0.24x

Understanding the business

The lens you use to look through to evaluate a business can make all the difference. This is how Morningstar views the business (emphasis mine): 

Emeco was caught dramatically by the contraction in mining and civil construction. Demand fell steeply in second-half 2009 causing a drop in utilisation rates. Still, it survived. It is among the most volatile of companies with cyclical demand, high operating leverage and heavy capital expenditure requirements.

When you look through the Morningstar lens it’s hard to see something to like, but I would argue that they are viewing the company from the wrong angle. Demand is certainly cyclical, but is the operating leverage really high? Are capex requirements a problem? Thanks to red. who has been blogging about Emeco since the end of 2012 I view things slightly different.

Operating leverage

Emeco is a rental company: they don’t own a large production facility with high fixed costs. The PP&E on their balance sheet is mostly dump trucks, excavators and other heavy equipment. When there are no customers it’s just sitting idle without draining cash, and without losing value: a truck that isn’t used isn’t subject to wear and tear. This is also recognized by the company in the accounting since depreciation is calculated and charged based on machine hours worked over their estimated useful life.

When you check the income statement you’ll see that the biggest costs are in fact variable costs: repairs and maintenance, and depreciation expense are the biggest expenses, and both are variable because it’s based on the utilisation rate of their rental fleet.

Heavy capital expenditure requirements

What I think is a second misunderstanding of the business are so called heavy capital expenditure requirements, because it’s actually an opportunity to adjust the balance sheet to demand. Last year the company recorded a depreciation expense of A$107 million for plant and equipment while it started the year with A$1,305,962 in gross P&E and A$793,128 in net P&E. That’s a lot of depreciation in a year where the average fleet utilisation was just 67%. If we do the math this implies that the average expected useful life of the equipment is a bit more than 8 years when fully utilized. What this means is that Emeco can relative easily shrink their rental fleet when demand is low. Simply stop reinvesting in new units, and normal wear and tear will reduce the fleet.

A second important implication of the relative short life of the heavy equipment (presumably when it’s used 24/7) is that idle equipment should retain it’s value even when worldwide mining activity would decline, because worldwide supply can shrink at the same time as demand. This is unlike shipping or oil drilling were ships/rigs can have 50 years of useful life. A long useful life means that supply is basically fixed, and that day rates can vary wildly without any apparent relation to replacement cost. The more often something needs to be replaced, the more relevant replacement value is.

Asset based valuation

Emeco’s rental fleet is classified on the balance sheet as a non-current asset as part of PP&E, but I think it makes more sense to view it as inventory and a current asset. It’s equipment that you can move around the world, and use for whatever you want to get out of the ground. Their equipment is probably easier to turn into cash than for example the inventory of AEY. If you classify Emeco’s P&E as a current asset the balance sheet looks as follows:

Adjusted Emeco balance sheet

Looking through the asset lens Emeco appears to be really cheap. It is trading at a 66% discount to adjusted NCAV, and at a 0.24x P/B ratio. The biggest part of Emeco’s asset value is derived from their equipment, and I believe that this is most likely worth book value based on the gains the company was able to book on asset disposals the past 5 years. In every single year since 2009 the company has sold a sizable amount of used equipment, and always slightly above book value:

Emeco disposal history

Based on the consistent history of selling equipment above book value I think that Emeco should roughly be worth tangible book value. This would imply a share price 3x above current levels. A concern is the high amount of debt that Emeco is carrying, but given the big discount there is still a reasonable margin of safety. The equipment could be marked down by 33% and Adjusted NCAV would still equal today’s market cap.

Looking at the amount of new mining equipment that Caterpillar is selling should also tell us something about the state of the second hand equipment market, and the market value of the equipment. In the first nine months of 2013 Caterpillar saw revenues in the resource industries segment drop with 33%, but that still means they were able to sell more than $10 billion in new equipment. If there is still demand for new equipment you have to figure that there is also demand for used equipment, and it’s easier to offer used equipment at a discount than to lower the prices of new equipment.

Debt sustainability

It’s not enough that the debt is backed by substantial tangible assets. The debt maturity profile, and the ability to meet debt covenants are quite important too. While I do think that their unused equipment can be converted to cash relative easily there are limits to their balance sheet flexibility. Selling ~A$50 million worth of equipment in a year is presumably easier than selling >A$100 million, and there certainly most be some correlation between their utilisation levels and the market for used heavy equipment. If they would sell their idle equipment today at book value they could generate enough cash to extinguish all debt, but it’s very unlikely that that would be possible.

They don’t have to worry about debt maturities: at the end of FY13 the average debt maturity profile was 4.9 years. Meeting the gearing and interest cover covenants might be closer though. They managed to temporarily amend the covenants to the following ratio’s:

  • Gearing: (Gross Debt/EBITDA) < 3.5x
  • Interest cover: (EBITDA/Net Interest Expense) > 3.5x

With an expected EBITDA level between A$90 and A$115 million for FY14 the debt needs to be reduced to A$315 million in the worst case scenario. The interest cover covenant wouldn’t be a problem either at this debt level. At the end of FY13 Emeco had A$415 million in debt, and this has been reduced to A$377 million today (in 4½ months time). At this repayment rate they would almost exactly end up at A$315 million in debt, so that’s encouraging to see.

We can also use the expected EBITDA level as a check to see how much equipment Emeco needs to sell in the worst case scenario to sufficiently reduce the outstanding debt:

+ 90M EBITDA (low-end of guidance)
– 30M Capex (low-end of guidance)
– 22M interest expense
= 38M in ‘free’ cash flow

Since debt needs to be reduced by A$100 million in FY14 in the worst case scenario they need to raise an additional A$62 million selling idle equipment. They have already sold A$24 million in the first 4½ months, so this seems a very doable amount. And with approximately A$400 million of idle equipment on the balance sheet there must the potential to quickly raise some money if they are willing to offer a discount. I can imagine that they could delay some capex as well, and perhaps liquidate some working capital. Emeco isn’t in the best position, but they should be able to handle their debt load.


I like buying companies were insiders own a significant amount of equity, but that’s unfortunately not the case at Emeco. The company does appear to have a good incentive plan though, and bonuses are mainly based on net profit after tax and return on capital. Emeco also has a good history of paying significant dividends to shareholders, and buying back shares. In the past 5 years they returned a total of A$171 million to shareholders. Looking at the past might not be the most useful exercise since the CEO is brand new.

What’s perhaps a negative – and certainly in hindsight seems to have been ill-timed –  is the large amount of money the company has been spending on (growth) capex in the past few years. Net capex (after asset disposals) in 2013 was A$129 million and 2012 was a record year with A$282 million in net capex. Paying down some debt would have been preferable.

The relative low insider ownership creates the risk that management doesn’t have the right incentive when the situation deteriorates further. They could for example be inclined to dilute shareholders by raising additional equity if they think that will save their job. The flip side of that coin is that a high debt level also forces management to do the right thing. Repaying debt is the #1 priority: there is no room to allocate capital to something stupid.


There is a lot more that could be said about Emeco, but what truly matters is that they own a lot of idle equipment, and that equipment can probably be sold close to book value to manage their debt level. That’s all there is to this idea…

Rating: on a scale from one to five I’m going to give this idea two stars. Their debt is a problem – that can probably be solved – but it reduces flexibility, and it might cause a lot of trouble in some scenario’s. Emeco is a bit risky, but potentially also high reward.


Author is long Emeco

Awilco Drilling reports Q3 results

Awilco Drilling reported an excellent third quarter with $46.3 million in EBITDA and a net profit of $36.6 million. Management is also keeping it’s word to pay out all excess cash flow, and is going to pay a $1.1 dividend next month (up from $1 the previous two quarters). Annualized this means that Awilco Drilling is still offering a yield above 20%. The dividend should be sustainable for at least the next couple of years since Awilco has signed contracts that extend into 2016/2017 with rates that are higher than today:

Awilco backlog as of today

More interesting is that the latest company presentation now also contains more information about the special periodic surveys (SPS) that will take place in 2016. The company estimates that this will result in 2 months downtime per rig and that it will cost $20 million per rig. Awilco Drilling will also upgrade the blowout preventers (BOPs) at the same time for a cool $45 million. With a estimated remaining fatigue life of 18 years for the rigs keeping the equipment up to date seems sensible. Check the milk illustration :D:

Awilco SPS ProjectAlso interesting is a new graph about the global midwater market, and the order book for new rigs worldwide. I bet they got a lot of questions from investors about this, because it always comes up when the company is discussed. The slide in question:

MW markets wordwide


Long Awilco Drilling

Learning from investing mistakes

One of the great things about investing is that you can learn a lot from other people’s mistakes without spending any money. It’s inevitable that you are going to make mistakes yourself, but you don’t get points for reinventing the wheel. So when someone decides to do a post-mortem on a failed investment I’m all ears. Especially since you usually see investors talking about their latest idea’s: not their failed idea’s. A good blog post that I recently linked to on Twitter was this one from Glenn Chan about junior miners, doing your own homework and how some things are just too difficult.

Sometimes you also read a post-mortem, and you wonder if the author really learned anything. Today I came across this blog post from Vitaliy Katsenelson titled “What I learned from the J.C. Penny Fiasco”. In the piece he argues that the JCP investment wasn’t a bad investment: it just didn’t work out. That’s of course possible: if you bet when the odds are in your favor you will win in the long-run, but it doesn’t mean that every bet will pay off.

But if you want to review your investment thesis you can’t just assume that your initial assessment of the probabilities was correct. Vitaliy thought that the probability of a turnaround at JCP was ~70 percent (with a lot of upside) and the probability of failure around 30 percent (with ~40% downside). If that would have been true an investment in JCP would have been a fantastic bet.

I doubt that this was the case, because there is simply not a lot of logic that supports the 70/30 probability distribution. How often are declining companies able to turn around? How often do retailers turn around? How often do companies turn around by trying a radically different strategy? How much experience did Ron Johnson have in turning around a struggling retailer? I don’t know the exact answers to all those questions, but I’m pretty sure that there would be absolutely nothing in the data to support a high probability of success. When you grab some bullshit probabilities from thin air it might be a good idea to start there in your post-mortem…


No position in JCP, so far just following the story for entertainment value