Description

Summary

Aggreko (LON:AGK) is the world’s largest provider of temporary power solutions. Aggreko has gone from a no-moat and a mediocre low returns on capital business (10% to 12%) in 2003 to a wide moat and a very high returns on capital business today (25% to 35%). The high ROCE is the result of their global integrated hub-and-spoke model allowing them to respond quickly to customer needs and thereby optimizing their fleet utilization. The business’ “wide” moat continues to widen thanks to their global scale and a unique low cost structure relative to other industry players (more on this later). The business has had significant tail winds due to the growing need of temporary power. Aggreko has compounded revenue by ~20% and EPS by ~30% over the last decade.  

We believe that Aggreko has plenty of growth runway ahead and a strategy in place to tap into this growth, yet the market is offering us the unique opportunity to own this phenomenal business at a very reasonable valuation EV/EBIT of 12x or P/E of 15x. Aggreko is trading at 1,527 pence as of Jan 31, 2014, very close to its 52 week low of 1,429 pence.

Aggreko has two large contracts (Japan and the Military) that are rolling off in 2013-2014 causing low visibility into revenue growth and margins in the near term. We believe that Aggreko’s business is inherently one of high variability and low visibility on a near-term basis, and is no cause for worry in the long-term (on  a five year rolling period). Mr. Market hates unpredictability and hence he is is offering us the opportunity to buy Aggreko at a reasonable valuation.

Business Overview

Aggreko is a specialist energy services business, offering temporary power and temperature control on a global basis. Their services are mission-critical, asset-intensive, often involving significant engineering input, and are frequently used in response to emergencies. Aggreko has a global presence in around hundred countries and has a very large power fleet that is capable of providing more than 9,100 MW of power. We highly recommend that you watch the five minute “Aggreko: What we do?” video before you read further. http://bit.ly/1cHhusr

(In £ millions except per share data in pence)

Aggreko has an outstanding track record over the last decade. Total shareholder return during this period has been ~1,000%.

The business operates in two segments: Local Business and Power Projects. Much of the business’ resources are shared across the two segments.

• Local Business rents power and temperature control equipment to commercial, industrial, utility and government users.

• Power Projects sells electricity, supplying and operating utility power plants, mainly in emerging markets to utility and government users.

Local Business

The Local business serves customers from 194 service centres in 47 countries in North, Central & South America, Europe, the Middle East, Africa, Asia and Australasia. This is a business with high transaction volumes: average contracts (excluding major events such as the Olympics where contracts can be worth tens of millions of pounds) have a value of around £17,000 and last a handful of weeks. The Local business represents 59% of Aggreko’s revenues, excluding pass-through fuel, and 45% of trading profit. Although most of this business is planned in advance, about 25% of its revenues come from responding to emergencies. It is therefore essential to have the capability to deploy equipment and people to the customer’s site within a matter of hours. Aggreko’s 194 service centres look after customers who are normally within a radius of 200 miles, and they offer the complete range of products and services.

EBIT margin and ROCE in the Local Business has nearly doubled since 2003. The Local Business was run out of standalone depots (59 in North America and 39 in Europe) in 2003. Each depot ran a separate P&L and was not measured on returns on capital employed (ROCE). Operational administration like call handling, contract management, local purchasing, and debt management was handled at the depot level.

The current CEO when he took over management in 2003 recognized the potential to improve Aggreko’s operations. The standalone depot business was restructured into a “hub-and-spoke” model which is in place to date. The model has two types of service centers: the hubs hold larger items of equipment as well as provide service and repair facilities; spokes are smaller and act as logistics points from which equipment can be delivered quickly to a customer’s site. The hubs and spokes are organised into areas in which a manager has responsibility for the revenues, profitability and the return on capital employed within that area. In this model, most administrative and call handling functions are carried out in central rental centers.

Power Projects

The Power Projects business sells power which Aggreko delivers using power plants built, owned and operated by them. Whereas in the Local business a contract with a customer is described in terms of renting specified items of equipment for a period of time, most of the contracts that Power Projects performs are for providing a defined amount of electrical power, for which a customer pays a fixed monthly capacity charge; they then pay, in addition, a variable charge for each MW-hour they take. Under the terms of these contracts, Aggreko is responsible for installing and operating the equipment and the invoice to the customer is for power generation capacity not equipment rented. Most projects in this business are worth over £1 million a year and some can be worth very much more than that; in 2012, Aggreko invoiced its largest utility customer around £95 million. A typical contract in this business would be for the rental of 20 to 50MW for an initial period of 6-12 months, which will often be extended. Aggreko’s power-plants are highly modular, and their capacity can be flexed in 1MW increments using standard containerised units of their own proprietary design, designed and built in their factory in Scotland; importantly, these generators are also in widespread use in the Local business, so fleet can be shared between the two businesses. They use either diesel or gas as fuel and are designed to be easily transportable, reliable and robust; in 2013 Aggreko also announced the availability of generators that can run on Heavy Fuel Oil, which is significantly cheaper than diesel. Power projects can arise anywhere in the world and the required response time is generally weeks rather than the hours or days needed in the Local business. To support these projects, Aggreko concentrates its fleet in a number of hubs – in Central America, Europe, the Middle East and Asia. From each hub, large amounts of equipment can be shipped or flown rapidly to wherever it is needed.

Power Projects customers are almost all in emerging markets and over 84% of their revenues come from utilities but Aggreko also serves governments, armed forces, as well as oil & gas and mining companies. In 2012, the Power Projects business generated revenues of £638 million, or 41% of Aggreko’s total revenue excluding pass-through fuel.

Aggreko’s strategy for the Power Projects business has been to grow as fast as it prudently can, to secure for itself the operating efficiencies and competitive advantages which come from being the largest global operator. So far, it has been very successful in executing this strategy and the Power Projects business is many times larger than its next largest competitor.

Global Scale and Competitive Advantages

The global hub-and-spoke model has allowed Aggreko to become more profitable over time in mature markets. The most profitable hubs have been the ones where Aggreko has dense network of service centers which share equipment, staff and customers, and benefit from low transport cost being physically close to customers. In the mature markets, Aggreko has focused on adding new service centers and upgrading the existing service centers to be more capable. At the same time, Aggreko has used the profitability in mature markets to expand its global footprint in fast-growing economies. This has helped Aggreko deliver ~30% compounded revenue growth over the last decade and gain significant market share from its competitors.

The resulting global scale has added yet another dimension to Aggreko’s competitive advantages. Standardised operating processes and investment in a single global IT platform has brought visibility and homogeneity. Global utilisation statistics have allowed Aggreko to spot where equipment is under-utilised, and where it can be moved to for the best return, and this has reflected in the increase in sales/gross rental assets, a financial measure of equipment utilisation; between 2004 and 2012, sales/gross rental assets in the Local business increased from 62% to 78%.

The reason why it is advantageous to be a global operator in Power Projects is because demand can shift rapidly between continents. In 2003, South America and Asia were probably the largest markets, and Africa was only a small proportion of global demand. In 2009, the market in Africa was larger than South America and Asia combined. In the last couple of years, the position (as measured by fleet-on-rent) reversed with South America and Asia representing around 50% of Aggreko’s fleet on rent. These shifts in demand were driven in part by rainfall patterns, in part by the relationship between economic growth and investment in permanent power generation, and in part by, geopolitical issues. To be successful in the long run, therefore, requires the ability to serve demand globally, and that requires sales, marketing, and operational infrastructure to be present in all major markets.

Being able to address demand on a worldwide basis means higher utilisation. When fleet returns from a customer at the end of a contract, the speed with which it can be put back on contract again is a major determinant of profitability and returns on capital. Fleet will find new work far more quickly if it can address the total pool of world demand than if it is only able to operate in a single region.  By the time customers have decided they really do have to spend money on temporary power, they generally want it as fast as possible. Being able to offer very fast delivery of large amounts of generating capacity is a significant competitive advantage. Small operators cannot afford to keep 250-300 MW of capacity (say, £30-£40 million of capital) sitting idle waiting for the next job. Because the equipment used in Power Projects is also used in the Local business fleet, Aggreko manages its large generators as a common global pool. Between the Local business and Power Projects, Aggreko currently has a fleet of over 6,000 of these large generators, and can deploy hundreds of MW of capacity from their various businesses around the world on very short notice. A good example of Aggreko’s speed of delivery would be the power contract in Japan where, in response to the Fukushima disaster, it was able to deliver and commission 200MW across 2 sites within 70 days of the contract signature; most of their competitors would find it difficult to deploy that amount of fleet in that lead time.

The management of risk is a critical part of Aggreko’s business; It places tens of millions of pounds worth of capital assets in countries where the operational, political and payment risks are high – sometimes very high. While it takes great care to mitigate these risks, it is probable that sooner or later Aggreko will have a loss of either receivables or equipment, or both. However, because of their scale, such a loss would not imperil the Group as a whole. Aggreko minimises the risk of losses doing material damage to the business by having a broad portfolio of exposures, none of them correlated. For smaller companies, their portfolio of country risk is inevitably much more concentrated; the probability of loss in any one country for smaller companies is no less than it is for them, but their ability to withstand the consequences of a large loss is. Scale therefore allows Aggreko to deal in markets where others might, with good reason, fear to tread.

Returns from rental businesses are heavily dependent upon the underlying capital cost of the rental fleet. Clearly, large buyers should get better terms than small buyers and, since Aggreko is by far the largest purchaser of power generation for rental applications in the world, by Aggreko’s estimates their capital cost/MW is typically 20-40% lower than competitors’. The fact that Aggreko has the scale to justify having its own manufacturing and design facilities also means that it can source equipment which is better suited to their precise requirements, and more cheaply, than smaller operators

Many rental businesses provide standard products to their customers. The car or hammer-drill you rent is the same as the one you can buy. Aggreko’s equipment is different: manufacturers of generators and temperature control equipment generally design their product to be installed and stay in the same location for its working life. For Aggreko’s business, however, this equipment has to be lifted and transported hundreds of times during its working life. It must be able to work in extreme conditions – the same generator might be working in –40°C on an oil rig in Russia one week, and in +50°C in the Saudi Arabian desert the next. Designing and building equipment that can do this, while remaining safe, quiet, reliable and compliant with environmental and safety regulations, is a key skill of Aggreko. Unusually for a rental company, Aggreko designs and manufactures most of its equipment and its specialist in-house teams based in Dumbarton, Scotland understand intimately the requirements of the environment in which the fleet operates. Not only does Aggreko have industry-leading equipment, it also has a great deal of it – £2,331 million worth at original cost as at 31 December 2012.Unlike most other rental businesses, Aggreko has a policy of keeping equipment for its useful life. This gives Aggreko a powerful incentive to maintain it well, which gives it both longer life and better reliability. Aggreko has a large number of skilled engineers, well-equipped workshops and rigorous servicing regimes to ensure that its equipment is maintained to the highest standards.

In summary, a large global operator will have lower volatility of demand, better lifetime utilisation of equipment, be better able to respond to customer requirements, and will have a lower capital cost per MW of fleet.

Valuation

For most of the last decade, Aggreko was a favorite among “growth” investors. Very rarely has Aggreko traded at < 15x P/E as it is trading today.

15x P/E may seem rich by traditional valuation standards, but here we have a business that has a long runway for growth at very high returns on incremental capital employed. We would argue that 15x P/E is not rich. For more thoughts on this topic, we recommend you to read this.

One of the reasons that Mr. Market is offering the opportunity to own this compounding machine at such a reasonable valuation is because of the relatively “dull” 2013-2014 outlook for Power Projects as a result of two big contracts, the Military and Japan, are rolling off.

In our opinion, this by no means a permanent impairment to Aggreko’s business and is a somewhat minor blip in our opinion to the Aggreko’s long runway of growth. Aggreko’s business has always been one of high variability and low visibility.

However, we are confident about Aggreko’s future primarily because of its top-class management team. Aggreko has been holding five year strategy sessions since 2003. Not only do they revise these goals every five years, but they also evaluate how they have done over the last five year period. Aggreko’s management team has not only overshot most of the goals, but is very upfront and accountable for the goals they have missed. We highly recommend that you read the strategy presentations on their investor relations website.

So, if we take their word (which we would argue they have more than earned), Aggreko is projecting the following for 2013-2017

In addition, as growth slows, Aggreko will be more cash generative as incremental capex slows down. Aggreko’s management believes that most of the excess cash will be returned to shareholders. If this is true, it isn’t hard to see how free cash flow can compound at 12-15%.

We believe that depreciation is a good proxy for maintenance capex for Aggreko. Using 30% tax rate, we get: Net Operating Income After Tax (NOPAT) = EBIT * (1 - Tax Rate). Assuming 2013 is a flat year, we have 2013 NOPAT = 385 * (1 - 0.3) = £270m. As per management, we assume NOPAT can grow at 12 - 15%. We get 2018E NOPAT = £475m - £540m. Using a terminal multiple of 15x (given that Aggreko can continue to grow slightly above inflation due to pricing power), we get 2018E enterprise value of  £7.1 - £8.1 billion. It is currently trading at an enterprise value of £4.6 billion. Backing out net debt of £500m, we get current market value to be £4.1 billion and 2018E to be £6.6 - £7.6 billion. If we discount for the time value at 10%, you see that if Aggreko grows at 12% CAGR for next 5 years, it is currently trading close to fair value and if it grows at 15% CAGR for next 5 years, it is trading at 70% of fair value. For a high quality wide moat business that has the ability to compound for much longer than 5 years, we think this is a great valuation to start a position at.                                             

Lastly, it is reinforcing to know that the managers at FPA International Funds own a 6% position in their portfolio at price levels not too different from here. Also, the Yacktman Funds started a small position (<1%) at these levels.

Risks

Running a business such as Aggreko’s is not without risks. The three main risks that can cause permanent impairment (all related to the fact that some of their operations are in political unstable jurisdictions) to Aggreko’s business are:

1. Political Risk

2. Failure to Collect Payments or Recover Assets

3. Failure to Conduct Business with Integrity and Honesty

All three are listed and well-addressed in our opinion in the risk section of the Annual Report. We believe that Aggreko’s management is well aware of these risks and has the appropriates measures in place to address to impact the Group’s business on a long-term basis.

Catalyst