Description

Long Consolidated Infrastructure Group

All values are given in Rand

I think the odds are by far in favor of a favorable outcome in this company given management quality and past performance.

The current valuation of about 2/3 net current asset value, 1.5-2.5 times run rate Price Earnings and a 2016 EV/EBITDA of less than 4 compensates for quite some near term uncertainty.

Consolidated Infrastructure Group was founded in its current form in 2008. Since then it has grown by acquiring other companies. Right now it consists of 5 major divisions:

The original division – made by acquiring 2 different companies - which started the company (then called Buildworks) is active in Building Materials. This is a really nice business manufacturing bricks and roof tiles but also mining aggregates like sand, gravel and stone. These businesses were bought by issuing shares to the owners in 2008. Although these companies are cyclical, they have some competitive moat due to high transportation costs. In 2009 they generated 162 million Rand in revenues and an EBITDA of 34.5 million. In 2017, due to some investments in new plant and equipment and some minor acquisitions financed by internally generated funds, these companies are generating R533 million in revenues and 99 million Rand in EBITDA. Even with the higher South African inflation, this is still a pretty impressive performance.
Some examples of smaller acquisitions in this division. In 2013 they acquired the Laezonia quarry from PPC for an amount less than PPC had invested in it just a few years earlier and turned it around by changing the mine-plan, altering recoveries and increasing capacity. Now, this quarry is one of their most profitable. Another Business they bought in this segment was Quarry Cats in 2013. It was bought for 20 Million Rand from Group Five, whom had paid 750 million Rand for it in 2006. It included a few quarries with a reasonable mine life left (between 15 and 30 years) and a business supplying construction materials and crushing services.

In 2009, the company took over Conco. Conco is, to quote management “the leading provider in South Africa and the African continent of turnkey solutions in the power and electrical industry. Its core business is high voltage substations, high voltage overhead lines, advanced protection and automation schemes as well as specializing in green energy projects, especially wind farms”.

When they acquired this company in 2009, for shares and cash totaling 497,5 million Rand, Conco was doing R1 billion in revenues with EBITDA of 128 million. In 2016, Conco had revenues of 3754 million and EBITDA of 364 million. In the last 2 years the origin of revenues has changed dramatically from almost 90% South Africa based to around 50/50 South Africa/Rest of Africa and the Middle East.

In 2012 the company made an offer to acquire a 30,5% equity interest in AES (Angola Environmental Services) for 261 million Rand. Due to delays with regulatory approval the acquisition was only finalized in 2014. AES is an oil services company which collects, recycles and disposes of waste generated in the oil production and drilling process from oil and gas rigs located off the coast of Angola. As one may expect, the profitability of this company has taken a beating in the last year or two. Even taking into consideration the poor timing, this investment has again been a home-run for the company. In 2.5 years’ time AES has already returned more than its original purchase price to the company. They bought their stake in the company ahead of a favorable rules change by the Angolan government banning all discharging of oil and fluids by drill rigs.

The recent fall in profitability was unavoidable given the continuing low oil price. However, AES is still making a profit and offers some nice optionality in case drilling resumes in Angola (i.e. a higher oil price). And according to management AES has enough liquidity and no debt so a cash injection is not needed near term if things would turn for the worse.

The other 69.5 percent in AES are owned by a private equity company and the founder. The private equity company has a put option for CIG to buy their stake (16% of the company) for 4.5 times EV/EBITDA. CIG has the option to defer this put for at least a year. It is reasonable to assume this put option won’t be exercised in the current low oil price environment.

In November 2014 CIG made a minor acquisition with Tractionel. Tractionel is the leading railway electrification and maintenance company in South Africa. This business has quite some synergies with Conco. The company was acquired for 121 million in cash without considering the positive working capital position. This has been one of the more expensive acquisitions in recent years, but still pretty cheap. EBITDA was 20 million at the time of the purchase.
Here again, the management has started to dramatically grow the company in just two years. Revenues have almost tripled, order book has more than quadrupled and EBITDA has almost doubled. 

The last acquisition (the 6^th in about 10 years) was Conlog after they were approached by French company Schneider Electric. Here again the shrewdness of management is very admirable. The purchase price was R850 million including earn-out (700 million plus 150 million earn-out).

Conlog was bought for a PE of around 6 excluding the working capital surplus on acquisition (normalized EBITDA is between 150 and 170 Rand a year). Conlog is a leading developer, manufacturer and distributor of pre-paid electricity meters, applications and support services. They have the number one market share in their niche of pre-paid electric meters in an African market which is expected to grow about 15% a year for the next decade if Africa will continue to electrify. A pre-paid meter is also more common in Africa for the obvious reason since electrical utilities face a lot of payment delinquency issues.

The Conlog acquisition is performing in line with management’s expectations (the performance even exceeded the highest hurdle of the deferred purchase consideration), which is an important point considering the recent negative updates at Conco.

It has to be mentioned that all major acquisitions listed above were financed at least in part by issuing equity. In general I’m not a very big fan of this practice but in the case of this company they used equity in a responsible way. Every acquisition was done at a low valuation (almost always below 6 times PE – Tractionel is the exception) for a growing company. And they never issued shares at a lower valuation then the company which they bought, thus ensuring EPS growth in the long run.

The rationale behind these dilutions was to avoid debt weighing down on the company. Like mentioned before, the acquisitions were always done with eps growth in mind. From 2009, eps for the group have grown from 50 cents a share to 2.5 Rand per share in 2016.

All these elements combined made CIG a market darling. Things have changed somewhat the last year.

As is to be expected, the most fragile but also the fastest growing division, Conco, is responsible.

The last few years the South African credit rating deteriorated materially due to political scandals in the Zuma government. Fiscally seen, South Africa is in better shape than many western countries given a 52% Debt to GDP ratio and a 3.8% government deficit (especially since their cost of debt is about 7-8%). This is not so bad considering the weak commodity markets and the higher expected GDP growth rate.

This has consequences for state-owned electrical utility ESKOM, which started a heavy investment program a few years back since black-outs are pretty common in South-Africa. Conco would have been one of the beneficiaries of these investment programs. They already won more than R2,3 billion in contracts and anticipate another 3 to 4 billion in contracts wins if more phases would get sanctioned.

The problem however is that Conco made commitments for some contracts, but that these contracts have been delayed (I guess mostly due to funding issues since ESKOM is facing a liquidity issue but politics is never far away in South Africa). The amount which has been delayed is 800 million as per management. These delays have some follow on issues like tying up personnel, inability to service other contracts in the meantime, cost overruns, etc... In addition to these issues, Conco had 3 bigger contracts in Africa which had lackluster performance (as management put it – uncharacteristically poor execution). Management however importantly did note that the underlying contracts would remain profitable.

3 SENS announcements later lowering profit guidance and mentioning contract issues caused the share price to drop by more than 75%. The meager performance at Conco was responsible for the evaporation of all CIG’s EBITDA last year. The lack of any EBITDA made the company trip their Debt to Ebitda loan covenant.

The million dollar question at the current share price is “what is the risk this company will face bankruptcy”?

On that note, there was some reassuring news recently. A few weeks ago the company reached a deal with its financiers extending the debt waiver for another year until march 2019. They are also in a pretty good positive working capital position with current assets almost covering total liabilities 1.5 times.

The main issue was the funding of these long term contracts. Contracts could take up to 2 years between start to finalization, and all equipment was financed in advance putting enormous strain on the balance sheet. Given that this working capital was financed with bonds which yielded 10%, this is an expensive solution. Btw, 10% is a pretty common interest rate for many south African companies, even large ones (10% is equal to a local Libor equivalent + 3%).

Management’s goal has been to work more “Just in Time” with these long duration contracts, thus eliminating large investments in current assets. In the last half year, even though they have experienced the execution delays mentioned above which tied up working capital, they managed to decrease current assets by 1 Billion rand (500 million rand of was used to repay current liabilities, 150 million was used to pay the Conlog earn-out, the rest was taken up by Conco losses). Hopefully they can continue on this path and release working capital to lower leverage some more.
In this way, combining a more JIT approach to contract execution and the return to profitability should restore CIG’s balance sheet.

Another way for the company to lower debt is by selling divisions. The most likely candidate would be the Building Materials division. A few years ago the company had mentioned the possibility of selling this “non-core” division but they had decided against it. Given their track record, I’m glad they hadn’t. But it would be an excellent way to remove market nervousness.

Given that all other divisions combined generate between 250 and 350 million Rand in net profit a year (including Conlog, of which they do not really want to disclose the net profit given that they deal with sophisticated buyers here) there is quite some margin to absorb some future Conco losses until they turn it around.

Most of CIG’s debt is bond debt with different maturities ranging from 2018 to 2021 with a nice even spread between the years. In the debt deal two weeks ago, they were given a repayment holiday lasting until 2019.

The last big risk factor, and something weighing down on the share price is the risk of a capital raise. There are some market participants fearful of such an event. Even if they would double the current share-count at a 30-50% discount to the current price, this would not be terrible for the current holders. This would meaningfully reduce debt to around 2/3 to half of the current amount and within a very manageable range. And the PE would only rise to become around 3 to 5 and the EV/EBITDA would probably just rise to 5-5.5.

Management

Together, management owns around 8.5% of the outstanding shares. This is less then I would have liked. In the early years of the company, management used to own more shares. Some of these holdings were because some companies in the early years were acquired by issuing share to the founders/owners. The decrease in management ownership is also related to the dilution from issuing shares in future acquisitions.

The CEO, Raoul Gamsu earned his stripes while turning around a Bidvest division at the age of 22. So he has some experience in turning around under-performing businesses. For those unfamiliar with South-Africa, Bidvest is a bit like SA’s General Electric. He seems very modest, entrepreneurial and socially active. He’s active in initiatives for encouraging entrepreneurship but also active in some Jewish non-profit and educational organizations.

Shareholdings

The shareholding is pretty much concentrated with retail investors the last few years. There were a few interesting large holders in the past, but these have all disappeared. Kingdom holdings, by Prince Al Waleed, used to be a large holder but his stake has been reduced substantially in the last few years from nearly 30% to less than 5% in 2016. Another interesting holder was the AlphaWealth Prime Small & Mid Cap Fund by Keith McLachlan. CIG used to be his largest position until the 3rd downgrade, when he sold his holding. The downgrades made him question the stability of the business and management competence regardless of price.

Catalyst

* Stabilizing the losses at the Conco subsidiary
* Better policital environment in South-Africa given Eskom uncertainties
* Further lowering working capital to lower debt
* The sale of a division to lower/eliminate debt