Description

·    Bradken is a ~A$467mm market cap company that manufactures engineered products primarily for the mining and energy industries. For example, Bradken designs and manufactures the metal tracks that go on the bottom of mobile mining equipment; the steel teeth that line the buckets of bulldozers; and the steel liners of mineral processing equipment such as mills.

o   While Bradken has enjoyed a good run for many years riding the Australian resource boom, investors have become spooked by the recent large declines in mining company capex, and have abandoned stocks that are perceived as being dependent on such capex, such as engineering firms and equipment manufacturers.

o   These concerns, together with recent declines in revenues and earnings, have caused Bradken’s stock to sell off, going from a high of $9.30/share in 2011 down to $6.00 in January of 2014, and now currently sitting at a multi-year low of $2.73.

o   As we will see, there are several reasons why Bradken has been excessively penalized by the market and is currently undervalued. In effect, the baby has been thrown out with the bathwater.

·         Examples of Bradken products:

·         The decline in capex by large mining companies such as BHP Billiton and Rio Tinto has been well publicized. The following slides, taken from recent investor presentations from these companies, summarize the issues:

BHP:

                Rio Tinto:

·         The important thing to note about these announcements is that they primarily refer to expansion capex. That is, the mining companies are still very much focused on preserving and increasing the production levels from their developed assets, as well as completing projects that are already far along in the construction process and close to being commissioned.

·         Why is this relevant to Bradken? Unlike many other mining equipment companies, the core of Bradken’s business centers around consumable products that wear away and need to be continually replaced. For example, the steel teeth on the lip of a bulldozer bucket that actually makes contact with the minerals. The sales of these products are primarily tied to production levels and not overall mining capex. The following slide, from Bradken’s fiscal 2014 investor presentation, shows the portion of sales that are consumable products:

·         To be sure, a portion of Bradken’s business (primarily sales to OEM equipment makers such as Caterpillar) has been seriously impacted by the slowdown in mining company capex. The point here is that this has already happened, and future reductions should be much more limited. As the company says in their investor presentation, they are now “well past the de-stocking and order cancellation stage in the last quarter of FY13 with improved order intake levels from that low point remaining stable throughout the year.”

o   The fact that the part of the business exposed to expansionary capex has already declined so much means that we are now primarily left with the defensible consumable piece, which should continue to perform well.

o   This core part of the business also has higher margins than the sales to the OEM mining equipment manufacturers (i.e., the part of the business reliant on mining company capex expansions) because Bradken is selling directly to the users of the products (i.e., the mining companies themselves).

·         Despite the fact that most of Bradken’s sales are consumable products that must be continuously replaced as they are used up, the recent downturn in the mining sector (particularly among Australian coal producers, which have been seriously hurt by cheap North American coal imports) has been so acute in some areas that certain miners have been putting off replacing these parts in order to conserve cash. Ultimately, this is leading to pent-up demand, as these parts will eventually need to be replaced, as discussed in the following excerpts from Bradken’s 2014 earnings call:

·         A reasonable objection here might be that manufacturing can be a high fixed-cost business, and thus Bradken might be dependent on the expansion capex related parts of the business in order to achieve sufficient capacity utilization in order to preserve margins as revenues decline. This is the other part of what makes Bradken remarkable—management has consistently claimed that ~85% of Bradken’s costs are variable, and this has been demonstrated by the consistency of the gross margins on the base consumables business, even during the height of the financial crisis, as shown in the following slide from Bradken’s 2014 earnings call presentation:

Here is the accompanying management commentary for this slide:

·         In addition to the highly variable cost structure at Bradken, another reason why they have been able to preserve margins during the downturn is that they made a concerted effort beginning several years ago to move production to lower cost geographies, particularly to Xuzhou, China. Originally this move was designed to support additional growth, but as sales have declined, the company has used the Chinese plant to essentially move production from very high-cost plants located in Australia over to China. This has led to large cost savings despite the fact that the Chinese plant was only ~20% utilized as of Feb. 2014 (source: Bradken Interim 2014 earnings call). Rather than using these cost savings to increase margins, Bradken has opted to preserve margins while helping its customers with lower pricing, as discussed in the following excerpts:

·         In a sense, the recent downturn has created an opportunity for Bradken. During the mining up-cycle, it would have been highly damaging to employee morale and opened management up to criticism if they were to aggressively shut down Australian manufacturing and move it to China. But the fact that the troubles in the mining industry are now so well understood in Australia has given a degree of cover to management to make these moves without appearing to sacrifice the moral high-ground. The move to China has also created a situation where Bradken can grow significantly without investing incremental capital, as described in the following earnings call excerpt:

·         The most recent reporting period for Bradken has exaggerated the impact of the downturn on the company’s profitability because management made a conscious decision to “hang on” to some overhead in case mining company capex suddenly turned around. Now that it is clear that it hasn’t, and management no longer expects it to in the near future, the company has decided to move forward with the lay-offs and restructuring to reflect the current reality. The company explains this in the following bullet points from their 2014 investor presentation:

·         Although Bradken has invested significantly in capital expenditures in recent years, much of this was to support growth or to construct the China facility.  Now that the China plant is finished, the amount of capex will decline considerably. In fact, the company has consistently claimed that its “stay in business capex”—that is, maintenance capex, is just 2.7% of sales, or ~$30.5mm annually, compared to run-rate D&A of $66mm:

·         So far, we’ve discussed why Bradken is a good business and shown why it has been perhaps excessively penalized by investor pessimism concerning the difficult environment for mining companies:

o   Defensible core of consumable products that are tied to production levels, which are not projected to fall.

o   Highly variable cost structure that has allowed them to preserve margins despite the recent declines in sales.

o   The parts of the business that are exposed to mining company expansion capex have already been hit hard, and shouldn’t get much worse going forward.

·         We’ve also discussed a couple factors which may lead to some outperformance in the future for Bradken’s operations:

o   Deferral by some customers (e.g., coal miners) of required replacement parts, creating  pent-up demand for consumables that will eventually come through as sales.

o   Very large degree of excess production capacity, particularly in the China facility; the company is using only 60%-65% of its capacity, and thus can significantly ramp up sales when the cycle eventually turns without needing incremental capital.

o   Management’s realization that the current cycle will last for a while, which has led the company to permanently shut down high-cost Australian production and move it to China, thus lowering the cost structure going forward.

·         All of this, however, ignores the all-important subject of valuation. This is the real reason why Bradken is a compelling long at the moment: even if you don’t give them any credit for a recovery in their end markets, Bradken is still very cheap on a free-cash-flow yield basis, especially considering the quality of the business and the historical margins and returns it has earned. And if you do given them some credit for a slight recovery, the valuation borders on the absurd.

·         First, let’s take a look at the last 4 fiscal years of results for Bradken. All the numbers below for underlying (i.e., adjusting for one-off charges and gains) EBITDA and net income come directly from Bradken’s investor presentations over the last few years:

·         As you can see, a recovery of the business back to its previous earnings power would imply that you are buying Bradken for under 5 times earnings, a ridiculously low multiple for a high quality industrial company with a focus on consumable products.

·         More interesting is that you can significantly beat up the numbers and still get a very reasonable valuation:

o   Despite the fact that the company has said that they expect “an improvement in order intake as delayed expenditure at mine sites is released and mine production volumes continue to increase” (source: 2014 investor presentation), we can assume a further 21% decline in sales.

o   And despite the company saying that “…initiatives are well underway to significantly reduce overheads as well as capitalise on the GET market share and low cost manufacturing capacity in Xuzhou” and that “benefits from the restructuring announced in May 2014 and other business remodeling strategies will begin to be realised in the FY15 results” (source: 2014 investor presentation),  we can assume a further decline in EBITDA margins, from 15.3% to just 11.1%—a level not reached by Bradken since 2006!

·         Even using these very tough assumptions (which are significantly below sell-side estimates, as we will see shortly), we end up with a very reasonable steady-state free-cash-flow yield of 9%:

·         While a 9% FCF yield is already pretty attractive, a moderately bullish scenario—with sales increasing ~6% and margins holding relatively steady—leads to an incredible 22% FCF yield, which is usually suggestive of a very troubled company facing secular, existential issues—something we absolutely know is not the case for Bradken. Furthermore, this upside scenario is not at all out of line with the sell-side consensus over the next two years, and is actually almost equal to the median estimate for fiscal 2016 (Note: these are slightly out of date now):

·         Also note that the above analysis ignores Bradken’s stake in the publicly traded Australian mining equipment company Austin Engineering, which Bradken attempted to buy in 2013 in a stock deal before abandoning it because it was no longer accretive. Bradken owns ~18mm shares of Austin, which are worth about $12.6mm. While this represents a small fraction of the value of Bradken, a case can be made that Austin is also quite undervalued at the moment, with its share price falling from $6.00 in 2013 down to $0.70 at the moment. 

Catalyst

• The market realizes that BKN is not as exposed to mining capex as the current valuation implies.
• Another takeover offer if financing markets improve.
• Margin improvements from cost cutting actions and better capacity utilization.