Description

Key Points

• Emeco owns and rents out mining/earth moving equipment to mining Companies
• 25% current FCF yield, and ~40% normalized FCF yield
• very high FCF yield, with still weak utilization levels, and therefore significant upside to cash flow when market recovers
• Market leader – ~2x the size of next competitor in its core Australian market
• Intelligent, solid and incentivized management team focused on ROIC, profits, and share price performance
• Good business with attractive ROIC/ROE
• Cash flow characteristics of the business misunderstood by the market
• Well positioned fleet of production focused assets
• Discount to TBV
• Recently buying back stock at higher levels than current stock price
• ~8% forward dividend yield

$370m market cap company

Emeco owns earth moving trucks ("Earth Moving Equipment Co" – EMECO).  You can see the types of equipment here: http://www.youtube.com/watch?v=j6epZ1KWQ0Y

We buy and lease these trucks.  Emeco is by far the largest owner and lessor in Australia.  Pretty simple.

From their H2 2012 conference call

“In round terms, with the current size asset base, the business can generate approximately $100 million in free cash flow each year [on 370mil mkt cap], which after paying ordinary dividends, provides financial flexibility to pursue various initiatives without adversely impacting the balance sheet. We see this flexibility as a valuable tool in managing the business across the cycle.”

- Stephen G. Gobby - Emeco CFO

Looking at slide #13 from their H1 13 investor presentation (http://www.openbriefing.com/Briefing.aspx/PDF/963) – they break out the half year free cash flows of the business – defined as CFO + Disposals of End of Life Fleet – Sustaining Capex.  Page 24 of the presentation is instructive as well, and lays out the math for cash flow before growth capex.  

Those half-year free cash flows are the below (in $mil AUD)

These are HALF year FCF numbers for a 370m market leading company which is conservatively financed.  Management is of the view that in today's slowed mining environment the business should generate $90+ of free cash flow (after maintaining the fleet), and generally should do $100 to $140mm.  This results in a current FCF yield of 25%, and a normalized fcf yield of 38%.  Mr. Market can sometimes be a real sweetheart.  The business has historically been able to generate very substantial cash flows.  In the last 12 months, the business paid $38m in dividends, repurchased $17m of stock, bought almost $300m in new equipment net of disposals while only borrowing ~$140m (against D&A of only 140m). 

There is nothing fundamentally wrong with the business except for a slowdown in its end markets (which has already been affecting the business for the last year and is reflected in current numbers) – but understanding how rental cash economics work will allow you to sleep very well at night. Emeco is a market leader with substantial market share (have heard ~30%) with cost advantages, run by solid management that is intelligently allocating capital.  There is no commercially viable way to produce coal, copper, gold, iron, etc other than to pull it out of the ground and you cannot move earth from the bottom of a pit to the top of the pit on the internet.  Emeco supplies into the opex of a mining company – not the exploration/development capex which is more at risk.  In short, Emeco is ultra-cheap.

In case you don’t read that part of the FT there is an Australian mining slowdown in the works, especially from the majors who are in some cases deferring opex due to new mandates from the top. The 30k foot view is that there are effectively 3 stages to a new mine: exploration, development, and production.  People want to focus on proven, commercially viable production (opex – pulling earth out of ground) right now as opposed to the first two, riskier stages (capex – drilling and building rails, etc). 

Production for most above ground mines effectively involves (a) blowing up some earth (b) using gigantic excavators to pick up some of that earth (c) putting the earth into a huge truck (d) driving the truck out of the pit to be processed and shipped to China (e) repeat.  Emeco owns the trucks and without trucks it’s hard to get the copper/ore/coal to China since trains don’t go directly into the bottom of the pit.  This would be a much riskier bet if you were dry leasing the exploration drills to juniors – but Emeco is not and yet analysts comp Emeco against mining services companies who face far greater exposure to reduced exploration spending.  Even if Emeco wasn't a leasing company the comparison would be inappropriate given the relative cyclicality of production vs exploration and development. 

Over the last few years, the business has scaled up the truck fleet, increasing its size and reducing its average age.  Today the market has slowed down.  But as anyone who has looked at a leasing company will know, the management of the business has a LOT of cash flow levers (which they understand) and the business is in an excellent position to produce substantial cash flows.  Sustaining capex for the fleet of trucks is related to hours driven vs. months of age and hence downturns in utilization do not effect free cash flow as much as the market assumes.  As such,  the market has completely missed the appropriate way to think about the nature of cash flows. 

On an LTM basis, this business trades under 3.5x EBITDA.  That will likely be closer to 4x on a forward basis.  With 2 turns of debt (which is extremely sustainable given the amount of capital sunk into the fleet in the past few years and cash flow levers) this makes the cash flow yield to equity extremely attractive. 

Management has demonstrated the ability of this business to produce $100m of FCF.  At 10x FCF that would make this a $1bn market cap, a 2.7x return from here.  Emeco is a market leader with an attractive ROIC business model with a strong network of depots, maintenance capabilities, the trust of the major market players to work on big job sites, use no operating leases (as opposed to some competitors), use modest and very cheap long term financing ($450m bank facility with large availability and $140m notes placed in HY issuance in the US with a 7 and 10 year maturity tranche at very attractive yields).  They certainly have a lower cost structure relative to competitors given their scale, as well as a much dee. 

Additionally, the management team is a good allocator of capital.  They see that the stock is attractive here and have bought some in.  They will be buying stock when it's cheap and when they can earn a good return buying trucks (utilization is high) and their stock is dear they have an attractive outlet with which to deploy capital.  Emeco has performed well in this cycle.  Importantly – they are compensated on ROIC and stock price and have never issued shares since the IPO.  Since that time they have re-positioned their fleet with the sole focus of production assets and away from anything civil or exploration related, even as exploration assets earned solid returns while they made that shift. In conversation they clearly get the concept of spending dollars at the highest possible IRR and will readily volunteer that they are not at all wedded to owning trucks.

The Emeco IPO left a bad taste in investors' mouths, and Australian investors are still somewhat scarred by it.  Two private equity funds took the business private in 2004 and IPO’d their stake down to ~5% in 2006 (under old management) at a peak multiple on peak earnings, earning 4x on their investment.  Investors who bought into the IPO got burned and the stock was tainted.  The shares were sold to the public in 2006 for $1.90 and have subsequently generated a lot of free cash flow.  They now trade for $0.62.

However, unlike other Australian mining companies that lived through the crash (Boart Longyear, Macamahon, etc) and diluted their shareholders at the bottom of the market with rights offerings and will never recover, the Emeco guys didn’t and won't – they haven’t issued shares and are buying in their stock now that it is cheap.

New management was brought in from outside the company and they are not empire builders.  They understand ROC, ROE, have their long term incentives tied to share price, and are unemotional about the business.  These guys are a market leader with mid-cycle ROC in the teens and the best cost of debt capital and liquidity in the sector.  Despite what the very high fcf yield may suggest, there is nothing wrong with the business except that end markets are currently challenged.  It is grouped with mining service sector companies (on which basis it still looks cheap) but analysts do not understand the cross-cycle cash flow characteristics of dry lease rental companies.  Management and people familiar with equipment rental companies understand these business characteristics but the mining analysts who cover them do not. 

In short:

Market leader

Attractive ROIC business

Solid management with proper incentives to drive "good behavior"

"No-brainer" 4x FCF valuation, with significant upside as market recovers

If the stock doubles it will still be 8x FCF and most of the stuff I’m seeing posted these days is still worse than that.  If it triples it’ll be 12x FCF, an understandable valuation for a market leader.  Company generates huge free cash flow and pays dividends, so investors get paid to wait.

Risks

• Further slowdown in mining
• Pricing pressure on rentals beyond what has happened
• Collapse in commodity prices and production to catastrophic levels

DISCLAIMERS

• I have an ownership interest in Emeco at the time of this write-up that can change at any time without notice. There are no plans to provide future updates on the authors buying or selling activities for this or other stocks. The author may buy or sell shares of Emeco without notice for any reason at any time.

Catalyst

• 4x FCF
• Pickup in utilization (although will probably affect the stock price more than the FCF b/c of market perceptions)
• People understanding dry-leasing vs. operational business economics