Update No. 176 – 15/08/14

Earnings season finally kicked off for EGP this week. Only 1 of the 21 holdings we are waiting on reported, 3 holdings report from a non-standard balance-date and wont report in August. Of the 20 still to report, 2 will report next week, 7 in the following week and the remaining 11 in the final week of August.

I will discuss in a little depth the one holding that has reported this week and recount a little of the interesting experience we have had as part-owners of the business. The business is Coffey International Limited, a business that offers geoservices, project management and like services globally in the transport, property, mining and oil & gas industries.

Our investment in Coffey is quite different from our usual holdings. The business was making (statutory) losses when we invested, was heavily indebted and in an industry where it was obvious to even the casual observer that an extended difficult period was ahead. Major restructuring would be required to properly size the overhead component of the business to the newly reduced revenue profile. The business (under a different management) had conducted an enormous number of debt financed acquisitions in the boom years leading up to the GFC, like so many others, it did not end well.

EGP first purchased shares in November 2012 at 33 cents per share. I had observed the business for an extended period decline from prices over $1 per share (actually in the lead-up to the GFC, an all-time high over $4.70 per share was set). I was finally tipped into action and a really thorough review leading to purchase after hearing a persuasive investment thesis laid out by an investor whose analysis I greatly respect.

The business briefly traded up at prices around 45c after our initial purchase before plummeting to 10c in May 2013. EGP were buyers over April and May 2013 at an average price of less than 16 cents per share (a high purchase of 20c and a low of 10.5c per share). We fluked our final purchase only 0.5c off the all-time low, the price very swiftly returned to the high teens thereafter.

I should point out that to date our investment in Coffey, whilst satisfactory, has not been a huge success story (yet). At Friday’s closing price of 31.5c per share, our IRR (internal rate of return) on the Coffey investment has been 22.7% which although above our long run average at EGP of about 18% annually after fees since inception is not materially different to our net of fee return of 23.5% since our first purchase of COF. When I drafted this post on Monday, the IRR for our Coffey investment was 16.6%, what a difference 4 days can make…

Without going into substantial detail about how the investment decision was made, I would point out that Coffey was a deleveraging business that was being run for cash, with some substantial restructuring charges detracting from both the cashflow and the reported statutory profit. Conceptually, such a business as debtload decreases can have an exponential increase in EPS without meaningful increases in revenue or improving business conditions, particularly if the debt being eliminated is high-interest (as was the case here).

Looking at the business at the end of FY2014, and EBITDA of about $26m was achieved after adding back in about $2.5m in restructuring costs. The net debt has dropped to $48.1m, giving an enterprise value of about $130m at 31.5cps. EV/EBITDA at that valuation is an unchallenging 5x. The operating cashflow for FY2014 was over $20m, which is substantial for a business with a capitalisation of a little over $80m (it was closer to $70m when I drafted the post) any way you slice it. Even when you remove $9.4m in Capex, the cashflows are still pretty impressive (bear in mind a good portion of that $9.4m is ‘growth’ Capex in the growing International Development business, ‘replacement’ or ‘maintenance’ Capex is meaningfully lower than that). What does not make the business look cheap is the P/E of around 20x FY2014 earnings, but I think I can demonstrate how I expect the earnings to rise sharply in FY2015 (and beyond).

Contracted revenues over the next 12 months are up nearly 20% on the same time last year, where contracted revenues of $281.1m resulted in total revenues of $628.1m. Given the current contracted revenues of $335.7m, it’s hard not to imagine FY2015 seeing revenues approach $700m. For the first time (since EGP invested) there are a number of tailwinds in place for Coffey. More than 100% of the increase in contracted revenue is in the higher margin International Development business (lower margin work is being replaced with higher margin work). Even within the laggard geoservices business, the majority of the increase in contracted revenues are in the international businesses which given a likely weak AU$ (the reporting currency) should see a double kick in coming years.

The annualised interest costs based on the second half of FY2014 are $7.0m, which is a drop of over $1.1m on the FY2014 finance costs. Assuming PBT holds steady through FY2015, the whole of that $1.1m falls to the PBT line.

Coming off a PBT of less than $6.4m, the extra $1.1m amounts to an increase in over 17% in PBT without any improvements in the underlying business.

But we should expect some improvement in the business. If the $628m in revenues becomes $700m as I have postulated above, and if the profit margin before interest & tax holds steady (it should increase as the majority of the contracted work is in higher margin areas), profit before interest and income tax should be around $16.2m as a base. With the annualised interest cost of $7.0m mentioned above (it should be lower as the deleveraging continues), PBT should be at least $9.2m. With a tax rate of 30%, there should be an NPAT of at least $6.44m in FY2015, which spread across the 255.8m shares on issue would amount to over 2.5cps, or a ‘forward’ P/E of less than 13x. The foregoing are a pretty low set of expectations, between the tailwinds discussed above, I would be fairly unsurprised to see earnings exceed 3cps in FY2015, with good opportunities for further growth in EPS as the deleveraging plays out.

A business as cash-generative as Coffey, once turned around and the debt stabilised (or better yet eliminated) should trade at a higher multiple than the market. A case can therefore be made that if Coffey generates 3cps in FY2015 that it could very well trade at a price close to, or exceeding 50cps a year or so hence. The value in the early 30cps range is not mind-boggling, but it sure was at 10.5cps…

These opportunities arise from time to time. Had you asked me in May 2013 (when we were buying Coffey shares for 10.5c) I’d have told you the market was priced about right. It is now 15 months later and the return from the market since then is just a little over 12% including dividends, so reckon I would have been about right with that assessment. The market doesn’t need to get blindingly cheap for good opportunities to arise (it sure is helpful though).

In case the foregoing sounds a little too ‘finger in the air’, I have some more detailed ideas about valuation, which naturally I will keep to myself, but in valuation, you really only need to be approximately right, and to avoid being exactly wrong – Tony Hansen 15/08/2014

EGP Fund No. 1 Pty Ltd. Up by 2.36%, trailing the benchmark by 0.86% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 74.35%, leading the benchmark by 41.13% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1.000 cent per share Franking Credit & 31 May 2014 Dividend of 7.000 cents per share plus 3.000 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}