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.

Insiders

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.

Conclusion

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.

Disclosure

Author is long Emeco

31 thoughts on “Emeco Holdings: a net-net in disguise

  1. Mackie

    AV,

    Had a very similar write-up in the works but you beat me to it! Great write-up though, I will likely just link to yours on my blog.

    I am long shares as well and see the business model flexibility as the key misunderstanding. It would be like if a mine operator could flip a switch and suddenly start producing a different commodity. Emeco can go where busines is healthy (Canada and Chile at the moment) and offset volatile markets at least to some extent.

    There will probably be some tax loss selling for the rest of the year on this one but if conditions stabilize and they can get debt under control next year, I think the upside could be considerable.

    -Mackie

    Reply
    1. Alpha Vulture Post author

      Would be nice to see another write-up: I’m sure your perspective isn’t totally identical, but I obviously like a link to my blog as well :P. Love your blog by the way!

      Reply
      1. Mackie

        Great point – fresh perspective is always welcomed in investing. Between you and red., the opportunity has been covered nicely but I’ll go ahead and post my view on it. Glad you have enjoyed the blog! Big fan of yours as well (read it start to finish!).

        Reply
    1. richard

      In the filing, I read the following: “The performance shares issued under the terms of the Emeco Holdings Limited Long Term Incentive Plan and Rules lapsed”. So I take this to mean that he hasn’t sold any shares, but instead that they were part of an incentive plan and his rights under that plan expired… What do you think?

      Reply
  2. GlennC

    There’s been a huge boom in mining over the past decade. You can clearly see it by how well Caterpillar and other equipment manufacturers are doing. I don’t understand how this company hasn’t made money. I don’t get it?

    Reply
    1. Alpha Vulture Post author

      How profitable the business has been in the past depends a bit on how you view it (do you want to count results from discontinued operations or goodwill impairments?): but no matter how you view it they certainly made money (and returned a lot of that money to shareholders).

      Reply
  3. bob

    What do you see as the pathway to value creation? Although the company is trading below NAV, I am not sure they will actually sell idle equipment to pay down debt? The company got into trouble this year because of low utilization – lack of rental demand. Then I am not sure who would actually want to buy their equipment.

    Regarding capital expenditure –
    In 2013 and 2012, their disclosed sustaining capex are 71.8 and 127.1 respectively. Their PP&E-specific depreciation are 103 and 126 respectively. So while the business doesn’t need to spend crazy amount of capex each year just to keep up with the competition, sustaining capex roughly offsets depreciation, making “owner earnings” about the same as reported income. So maybe the company is not that cheap if we value it from a cash flow/earnings perspective?

    Reply
    1. Alpha Vulture Post author

      Selling idle equipment is the only option that the company has to manager their debt level: that is what they have committed themselves to do this year and this is what they have been doing. And just because their utilisation is low, it doesn’t mean that the market for their equipment is dead. It’s just that as a rental company a slowdown in demand will have a disproportionate effect on utilisation because of the nature of their business.

      About capex: seeing capex equal depreciation does indeed mean that reported earnings are also ‘owner earnings’, but it also implies that the book value of the assets is roughly equal to the economic value. The downside scenario is basically that the company needs to partly liquidate itself, so what matters is the asset value. And what remains should be valued using cash flow or earnings, but the remaining assets on a going concern basis are certainly worth more than in a liquidation scenario. They do generate solid revenue and cash flow numbers from the equipment that isn’t idle.

      Reply
  4. John

    Opened a position. The more I see, the more I like.
    Any thoughts on the catalyst for a more appropriate valuation? timing?
    Also, are they committed to paying dividends as they move forward / liquidate equipment? Is that likely to continue to be part of the investment thesis?

    Reply
    1. Alpha Vulture Post author

      I think that simply surviving the next few years and showing investors that they can pay down their debt will be a good catalyst. You don’t need to expect a dividend in the near future, they are actually prohibited from paying one, or repurchasing shares, as part of the deal to modify their debt covenants.

      Reply
  5. John

    Scenarios?
    1) Survival – claw their way back to operational business model with appropriate multiple, and maybe renegotiate debt covenents along the way (investment results later)
    2) Not Survival – liquidation and pay out (sooner?)
    3) Acquired? – werent some hedge funds rebuffed by them recently?
    other?

    Reply
  6. moti

    Hi,
    Can’t figure out your numbers in the P&E disposals – where do ‘gain on disposals’ and ‘total disposals’ come from??

    Reply
  7. Ron

    1H report is out, and seems like the debt covenants may be challenging given the 2H guidance.
    Are they going to go back for another change to the covenants?

    Reply
    1. Alpha Vulture Post author

      Seems to me that they are on track to meet the covenants. Now 320M in debt, and mid-point of EBITDA guidance is 88M. So debt would need to be reduced to 88*3.5=308M (and 287M for low-end of guidance). Should be doable, and I assume they can always speed up asset sales if required by offering a bigger discount.

      Reply
    1. Alpha Vulture Post author

      I’d say it’s slightly negative news. I assume that the new debt will have lighter covenants, but probably a higher interest rate as well. Don’t think it’s a good sign that they are looking to refinance because the debt maturity is 4 years from now or something like that; you don’t refinance because you want to, you do it because you have to…

      Reply
  8. Brad

    Emeco Holdings Limited (ASX:EHL) (‘the Company’) today announced that it has been assigned the credit ratings as follows from the principal rating agencies:
    • Standard & Poor’s assigned Emeco a corporate rating of B+ with a stable outlook;
    • Moody’s Investor Services assigned Emeco a corporate rating of B1 with a stable outlook; and
    • Fitch Ratings assigned Emeco a corporate rating of B+ with a stable outlook.

    Reply

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