Description

ALL AMOUNTS $AUD
FISCAL YEAR ENDS JUNE

INVESTMENT RECOMMENDATION
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Emeco Holdings (EHL AU, AUD$0.25, $150MM market cap) is a mining equipment rental business, headquartered in Australia.  EHL essentially provides swing capacity to large miners in Australia, Canada, and Chile (Indonesia is in wind down/strategic review).  Results are depressed by a decline in commodity prices, with FY14 EBITDA likely down ~60% vs. the FY09-FY12 average. 

EHL is an unloved equity, down nearly 60% in the LTM period.  It has (i) weak operating results, (ii) a halted dividend, (iii) a small market capitalization, and (iv) high leverage (75% of TEV).  EHL will not pay a dividend in FY14 (unlike FY13 where they not only paid a $37mm dividend, but also repurchased $24mm of shares). 

However, EHL is attractive.  Firstly, the equity is trading at liquidation value (valuing assets at ~60% and liabilities at ~100%).  Secondly, EHL has enough liquidity to survive a prolonged mining downtown; even with EBITDA down 60%, the Company is FCF positive, and can deleverage further by monetizing underutilized assets.  Simply put, EHL can materially reduce capital expenditures in down cycles (which is why TEV/EBIT increases in 2014, while the FCF valuation improves). 

EHL represents an attractive option on either, (i) mining service recovery, (ii) higher liquidation value than we assumed, and (iii) any M&A take-out.  Indeed, private equity tried as recently as April 2013 to acquire the Company for ~$0.76/share, which represents 200% upside and ~1x P/B.  A normalized FCF valuation would see a valuation of ~$1/share, representing 300% upside.  Peak valuations have been as high as $2/share. 

Thus, buying EHL is buying a cheap option on the mining cycle, supported by investing at liquidation value.  If you buy EHL at ~$0.25, you may not lose a lot of money (trading around liquidation value), but could earn 3x MOIC in the next 12 months (a revised private equity bid) and potentially 4x over a cycle (normalized FCF valuation).  Near-term results will be weak as the mining slowdown persists in FY2014, but this is not new news.  If conditions worsen or do not improve into FY2015, the stock may be further pressured and may just get very, very cheap.

The 3.5x leverage covenant, assuming $377mm of debt, implies a FY14 EBITDA threshold of ~$110mm.  This threshold contrasts with management guidance for $90-$105mm EBITDA.  Assuming $90mm EBITDA, EHL would need to deleverage a further $62mm subsequent to November 2013 to achieve a 3.5x ratio.

This $62mm of requisite deleveraging seems reasonable, as (i) EHL can sell assets from an $800MM+ fleet that is only 43% utilized and (ii) EHL will soon benefit from $20-40MM of W/C reversals (A/R, A/P and collection of $20MM tax receivable).  Between Jun-Nov 2013, EHL reportedly sold $24MM of assets.  As later explained, there is significant asset coverage through the debt, and thus banks (or a new vulture lender) should be comfortable amending/extending debt maturities (especially at higher interest rates).

Further, EHL should remain modestly FCF positive in FY14 (~$20mm, ex W/C).  The depressed operating environment hurts EBITDA, but also reduces capex spending and cash taxes.  As explained later, EBITDA would probably need to decline below ~$35MM to drive negative FCF (vs. 2014E $90mm and 2009-12 Average $240MM). 

       CAPITALIZATION       MATURITY        6/30/13
       =============================================
       Assumed Excess Cash                  -

       $450MM Revolver      2015-17         249.6
       $22MM W/C Facility   11/16/13        5.3
       Lease liabilities                    12.4
       Insurance financing  8/31/13         0.5
       USD Notes            5/22/19         53.3
       USD Notes            5/22/22         94.4

       --------------------------------------------
          Net Total Debt                    $415.4 <<< Reduced to $377mm                      

       Equity (600MM shares at $0.25)       149.9
       --------------------------------------------
          TEV                               $565.3 <<< Reduced to $527mm

 
BUSINESS OVERVIEW
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EHL is a mining equipment rental business, founded in 1972 and headquartered in Australia.  The business saw significant growth in 2004-07 under private equity ownership, actively growing via M&A.  Subsequently, the Company has focused on mining, having exited a civil equipment rental business and certain geographies.  The Company is currently focused on mining production in Australia, Canada (oil sands), Indonesia, and is expanding into Chile/South America.

EHL is effectively a provider of mining production swing capacity.  EHL’s customer contracts are not long-term in nature.  Contracts typically are take-of-pay with minimum guaranteed hours.  However, a typical 1YR take-or-pay contract may have only 3 months cancellation notice.  Further, that 1YR contract may have shrunk to 6 months in the current environment. 

The equipment rental business is characterized by high capital intensity, and EHL’s customers tend to be large miners.  Indeed, many of EHL’s customers have cheaper sourcing for mining equipment.  Further, it is cheaper for miners to buy equipment outright, versus rent.

So why do customers use EHL?  Chiefly, swing capacity has an industry role, helping miners meet demand in peak periods and reduce capex spend in troth periods.  Additionally, EHL provides certainty of service: equipment up-time is very important for miners and parts-and-service costs can represent 2-3x the cost of the equipment over its life-time (Caterpillar estimates ~3x for mining; Joy Global estimates 2-3x over its entire fleet).

While there are reasonable barriers of entry for this business, the industry is fragmented.  Barriers include the necessary capital to acquire equipment at low costs, a track record of safety, a track record of maintaining assets (e.g., uptime), and customer relationships.  EHL also operates in a larger asset class than most competitors (i.e., higher equipment costs) and is one of the few global players (and thus diversifying against geographic concentration risks).

       END MARKETS
       ================================================
                  2013                       2012 2013
                  ----                       ---- ----
       Australia  61%        Thermal Coal    34%  30%
       Canada     21%        Gold            19%  21%
       Indonesia  14%        Oil Sands       12%  20%
       Chile      4%         Coking Coal     16%  11%
                             Iron Ore        6%   7%
                             Copper          N/A 4%
                             Zinc            10%  N/A
                             Civil           2%   N/A
                             Other           1%   7%

WEAK RESULTS
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       REPORTED SEGMENT EBITDA
       ====================================================================
                            2010 2011 2012 2013      2014E(?)   ex-Indo
                            ---- ---- ---- ---       ---        ---
       Australia            $143 $186 $216 $122      $61       $61
       Indonesia            34   21   25   28        (10)       0
       Canada               15   33   36   47        47         47
       Chile                                11       11         11
                            ---- ---- ---- ---       ---        ---
          EBITDA            $192 $240 $277 $207      $109       $119
       Corporate            (2) (17) (15) (19)      (19)       (19)
                            ---- ---- ---- ---       ---        ---
          Total EBITDA      $190 $223 $262 $188      $90        $100

Earnings are weak, and will get weaker.  FY2013 EBITDA (FYE June) is down ~30%, with weak 2H13 results accelerating into FY14.  Global fleet utilization has decreased from an average 86% in FY12, to 50% at year-end June 2013, and is only 43% as of November 2013. 

This decline has been driven by falling commodity prices, especially hitting the Australia & Indonesian businesses.  The Company noted on its August 2013 earnings call, “we saw the impact of the combination of declining commodity prices and high costs that led to many customers reviewing their mine plans, overburden works were cut back and in many cases the miners are doing more with less in the pursuit of productivity improvements”. 

Australia utilization was 41% exiting FY13, down from an average of 92% in FY12.  Given relatively short-term contracts, the majority of commodity price declines should be reflected in FY14 results.  Indeed, in November 2013, management suggested results may have trothed as customer inquiries have increased.

Indonesia is currently at zero utilization, hurt by falling gold and thermal coal prices.  The negative $10mm EBITDA in FY14 represents ongoing expense to maintain a minimal operation (after laying off 2/3 of staff), while management completes a strategic review of the business.  The negative $10MM EBITDA contribution from Indonesia should be temporary, as either Indonesia is shut down, sold, or improves.

Canada (oil sands) and Chile (a LatAm growth expansion) remain bright spots for the business.

Forecasting future results is tough.  Clearly, EHL did not forecast the weak 2013 environment given elevated growth capex spent in 2012 and 1H13.  Caterpillar (who supplies 80% of EHL’s equipment) has explicitly stated the market “tough to forecast” and “we are not out there in the short-term going to try and call the timing of a turnaround”.

That said, we know FY2014 will be weak.  In December 2013, Citi forecasted a mining capex decline of 17% YOY in ‘14.  Miners take divergent views on near-term prospects for thermal coal, but all believe long-term demand will grow due to emerging markets demand.  Coking coal prices are below FY13 averages, so further weakness here should be expected.  Gold prices have been particularly weak, and this is reflected in Indonesia’s weak results.

HOWEVER, EHL WILL GENERATE POSITIVE FCF IN THE DOWNTURN
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EHL has halted capex in this recessionary environment, thereby aging its fleet.  EHL’s fleet is about 4-5 years, which is mid-cycle per management guidance for a 8-10 year useful life.  While we do not have a publicly reported aging for EHL’s fleet, management has believes their fleet age profile is “like a bell curve”.  Notably, EHL has spent ~$500MM on capex in last two years, and $850MM in last four years (vs. $1.3BN gross PP&E as of 6/30). 

In fact, the Company drove positive FCF in 2H13 via simply shutting down capex.  2H13 saw EBITDA down $40MM YOY, but capex lower by $100MM.  Despite, a large drop in EBITDA, FCF was higher by $40MM YOY (taxes & interest were ~flat YOY).

       HISTORICAL FCF BRIDGE (FYE June)
       =================================================
                       2009 2010   2011 2012  2013  2H13
                       ---------------------------  ----
       EBITDA          $236 $232  $229  $263  $187  $79
       Capex           (94) (108) (161) 282)  (129  (4)
       Other           2    9     (2)   1     0     10
       Cash Taxes      (36) (18)  (16) (16)   (18)  (7)
       Cash Interest   (21) (21)  (21) (23)   (26)  (13)
                       ---------------------------  ---- 
          FCF          $86   $96   $30 ($57)   $14  $65

Excluding “growth” capex, and including only “sustaining capex” (sustaining = maintain a given period operating performance), EHL has been consistently produced positive FCF.

       HISTORICAL FCF BRIDGE – EXCLUDE GROWTH CAPEX (FYE June)
       ======================================================
                            2009  2010  2011  2012  2013
                            ----------------------------
       EBITDA               $236  $232  $229  $263  $187
       Capex (Sustaining)   (63)  (71)  (112) (147) (89)
       Other                2      9    (2)    1    0   
       Cash Taxes           (36)  (18)  (16)  (16)  (18)
       Cash Interest        (21)  (21)  (21)  (23)  (26)
                            ----------------------------
          FCF               $117  $133  $79  $78    $55 

EHL management believes EBITDA would need to decline to $30-$40MM to drive negative FCF.  This threshold basically represents little more than interest expense.  At ~$35MM EBITDA, EHL would spend zero on capex (given very low equipment utilization), and would pay zero cash taxes (EBITDA would offset by D&A and interest expense). 

A persistent EBITDA decline to $30-40MM seems unlikely.  Firstly, the Canadian and Chile operations alone represent $40MM of EBITDA (inclusive of current corporate expense, which would shrink if EHL exited Australia and Indonesia). Canadian oil sand production forecasts remain bullish, and management believes its Chilean customers are low-cost operators.  Secondly, this EBITDA level would represent an 85% decline from the recent 5YR cycle, and is thus an unlikely run-rate. 

EHL’S BUSINESS WILL EVENTUALLY TURN
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Caterpillar supplies 80% of EHL’s fleet.  Caterpillar has suggested the decline in mining capex could soon stabilize.  In a recent investor presentation, Caterpillar reviewed their business and stated, (i) large mining trucks have declined the most of their segments, (ii) dealer inventories were bloated entering the 2013 slow down, and (iii) "inventory reductions are about done and that [is] a positive".  Additionally, Caterpillar believes customers are at the tail end of aging their equipment, citing (i) “we have seen evidence of where they are kind of pushing out maintenance times”, and (ii) “"remember in an industry like mining the most important thing to the customer is the cost per ton of what they get extracted and uptime … you can't defer maintenance forever”. 

NORMALIZED VALUATION MAY BE OVER $1/SHARE (5X MOIC)
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A reasonable, normalized valuation for EHL may be $1/share.  Indeed, EHL traded at $1.20/share in 2011, when results were stable and the S&P was 50% below current trading levels.  EHL traded at $2/share in 2007.

       HISTORICAL FCF – USE “SUSTAINING” CAPEX (FYE June)
       ==================================================
                             2009  2010 2011 2012  2013
                             --------------------------
       EBITDA                $236 $232 $229  $263  $187
       Capex (Sustaining)   (63)  (71) (112) (147) (89)
       Other                 2    9    (2)   1     0   
       Cash Taxes           (36)  (18) (16)  (16)  (18)
       Cash Interest        (21)  (21) (21)  (23)  (26)
                             --------------------------
          FCF               $117  $133  $79   $78   $55 

       ASSUME 15% NORMALIZED FCF YIELD
       ==================================================
       5YR AVG FCF:     $92MM
       FCF YIELD:       15%
       IMPLIED EQUITY:  $615MM
       IMPLIED $/SHARE: $1.03
       MOIC:            4.5x

       FY13 FCF:       $55MM (higher than FY14, but still depressed)
       FCF YIELD:      15%
       IMPLIED $/SHARE:$0.61
       MOIC:           2.7x

EHL’s PP&E consists of large mining equipment, ~80% of which is caterpillar equipment (EHL’s customers want caterpillar equipment to match their existing owned fleets).  This equipment can be very, very large: mining dump trucks can weigh 50-240 tons, and excavators can weigh 40-500 tons.  This equipment has use across geographies, but transportation cost to move a $15MM piece of equipment can be $500K (~3% of value).  Equipment models do not materially change much year-to-year, preserving large fleet investments.

        EHL Equipment Mix
       ==========================
       Rigid Dump Trucks    42%
       Dozer                18%
       Excavator            10%
       Grader               7%
       Wheel loader         6%
       Art. Dump Truck      7%
       Other                10%

EQUITY CURRENTLY TRADING AT LIQUIDATION VALUE
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A reasonable liquidation of EHL’s balance sheet suggests a $0.24/share liquidation value (vs. current trading price of $0.25).  PP&E valuation is *THE* material driver of this valuation.

        LIQUIDATION ANALYSIS     
       ======================================================       
                               B/S               Recovery  
                               6/30/13           %    $
                               -------           ----------
       Cash                       5.8            -    -
       A/R                       97.1            80%  78
       Derivatives                0.7            70%  0
       Inventories               14.8            50%  7
       Prepayments                3.0            40%  1
       Current tax assets        13.9            40%  6
       Assets held for sale       7.2            40%  3
                               -------           ----------
          Current Assets       $142.4            67%  $95

       Trade & A/R                0.9            80%  1
       Derivatives                4.5            55%  2
       Intangible assets        158.1            -    -
       PP&E                     820.2            70%  574
       Deferred tax assets          -            -    -
                               -------           ----------
          Total Assets        $1,126.0           60%  $672

 
We keep all liabilities at 100% (which is reasonable, given a relatively clean balance sheet), and a nominal amount of restructuring costs (someone must pay the lawyers).

       LIQUIDATION RECOVERY TO EQUITY
       ======================================================
       Distributable Value             $672
       ( - ) Restructuring Costs (2%)  (13)
                                        -----
          Net Distributable Value      $659

       ( - ) Current Liabilities       (55)
       ( - ) LT Liabilities            (460)
                                        -----
          Value to Equity              $144
          Shares Outstanding           $600
                                        ----- 
          $ / Share                    $0.24
          % to Current $0.25              -4%

A reasonable investor may ask whether our asset recovery assumptions are reasonable. Below is a stab at valuing the two largest assets: PP&E and A/R.

PP&E RECOVERY
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Assuming 70% for PP&E appears to be reasonable, if not conservative.  In establishing a recovery range, there are a few key data points to be aware of, including, (i) management has historically sold assets with gain-on-sales, (ii) despite the troth environment, management may have recently sold assets at a only a 10-15% loss, (iii) management believes their asset disposals are skewed toward older assets, and (iv) management may be aggressively depreciating its assets, modestly depressing book values.

EHL has consistently disposed of $30-50MM of non-current assets on an annual basis.  EHL has been recording accounting gains on these sales, suggesting EHL is recovering *over book value* for these assets (which again, represent older assets than the rest of EHL’s fleet).  However, book gains have been netted out in the cash flow statement, suggesting cash proceeds may be closer to book value (EHL’s accounting is unclear).  Further complicating matters is a separate reporting segment which sells machinery & parts; this segment has been running at a small loss; including this segment’s losses would suggest EHL sold equipment in 2013 at a small loss, and the worst performance would have been a 16% loss in 2011 (versus a +21% gain in 2009). 

EHL’s accounting is not fully transparent, but below are three potential accounting perspectives, which generally show EHL has been realizing about book value for its PP&E disposals (which supposedly are also geared towards older assets).  If EHL management is truthfully not cherry picking their equipment sales, they are demonstrating (i) demand for their equipment, and (ii) a high maintenance standard.  Further, EHL is directly selling its equipment to customers, avoiding the auction markets and associated fees.
 

                                            2009 2010 2011 2012 2013
                                           --------------------------
       Method 1: Income vs. Asset Sales                                          
       Profit on Non-Current Assets         $3   $3   $3   $4   $2
       Disposal of Non-Current Assets       $21  $48  $39  $35  $50
          % Profit                          13%  6%   7%   10%  4%                                                

       Method 2: Cash Income vs. Asset Sales                               
       Cash Profit on Non-Current Assets    ($1) $2   $0  ($0)  -
       Disposal of Non-Current Assets       $21  $48  $39  $35 $50
          % Profit                          -5%  5%   0%  -1%   -

       Method 3: Include Sale of Machinery of Parts
       Cash Profit on Non-Current Assets    ($1) $2   $0  ($0)  -
       Sale of Machinery & Parts            $6  ($8) ($7) ($2) ($1)
                                           --------------------------
       Adjusted Gains                       $4  ($5) ($6) ($2) ($1)
       Disposal of Non-Current Assets       $21  $48  $39  $35  $50
          % Profit                          21%  -11% -16% -7%  -3%

As previously noted, EHL recently sold $24MM of equipment into the currently depressed mining services market (EHL is not the only company with idle equipment).  Management claims to have sold this equipment with only a 10-15% book loss.

Perhaps most importantly, EHL may be aggressively depreciating its equipment. 

If we focus on D&A vs. sustaining capex for the period, we see D&A has been running 30% higher than what management determines sustaining capex to be.  EHL’s depreciation policy may just be conservative (for example, aggressively depreciating idle equipment).  Over time, this incremental depreciation accumulates - until a piece of equipment is monetized.

                            2009 2010 2011 2012 2013
                            --------------------------
       D&A                  $105 $108 $125 $136 $113
       Sustaining Capex     $63  $71  $112 $147 $89
       Ratio                1.7x 1.5x 1.1x 0.9x 1.3x

                            5YR Average: 1.30x        

Another back-of-envelope check is comparing D&A to gross PP&E.  Average gross PP&E from FY12-13 is $1,340MM, with FY13 D&A of $113MM.  Given 2013 depreciation of $113MM, this would imply a 12YR average useful life for equipment.  Given management estimates its equipment has a useful life of 8-10YR, 12YR seems conservative.  However, FY13 utilization was only 67%.  If you assume a 9YR useful life, adjusted for a 67% utilization rate, once would expect EHL to be depreciating currently to a blended 13-14YR average useful life, not 12YRs.

So why is 70% liquidation value appropriate?  Arguably, an 85% recovery could be one’s ‘base case’ (based on the recent asset sale).  However, it may be prudent to be conservative given, (i) EHL has been selling only < 10% of its net PP&E in any given year, (ii) EHL may be forced to pay auction houses to facilitate a global liquidation, (iii) transportation add up when moving equipment between geographies, (iv) an environment where EHL is liquidating its equipment is clearly a bad one, and (iv) liquidation analyses should be conservative, reflecting time value to effectuate a sale/wind down and lack of equipment appraisals to refine one’s analysis.  EHL’s equipment is not the type of liquid equipment that you may associate with commonly known U.S. equipment rental companies, such as United Rentals (URI).

As a reminder, EHL does not need to liquidate its entire fleet.  43% is currently utilized and the Canadian Oil Sands and Chilean operations appear not only viable, but profitable.

A/R RECOVERY
-------------
75% of gross A/R is either insured or owed by a blue chip customer.  20% of A/R is a tax receivable.  Thus, a 90%+ recovery is possible.  However, A/R days have increased materially over the past twelve months (from ~65 to ~80, inclusive of the tax receivable) and is worth monitoring.  We assume 80% A/R recovery in our mid-case. 

RISKS
**************************************************************************** 
(1)     FY2014 results will be very weak:  sub-$100MM EBITDA is likely
(2)     FY2015 results are hard to forecast
(3)     Thesis hinges on PP&E recovery:  If our PP&E recovery is too high (say a global meltdown materializes and all mining activity halts), the stock could recover zero.  A downside recovery case (valuing PP&E at 60%) results in ~$0.08/share recovery, or 70% downside.
(4)     Competitive landscape:  OEMs/dealers may be tempted to enter into the leasing market to earn a ROIC on bloated inventory.  However, Caterpillar, on their recent earnings call, stated their belief that dealer inventories are now approaching normalized levels. 
(5)     The stock is illiquid:  Average volume of ~5MM shares at $0.25/share = $1.25MM average volume.
(6)     Low insider ownership:  D&O own ~1% of shares outstanding.  Old management previously erred by turning away private equity bids at

Catalyst

(1)  Sale of the business to a Private Equity
------------------------------------------------- 
With EHL now trading at ~$0.25/share and at liquidation value, it is eminently feasible for Platinum (or another equity sponsor) to purchase EHL for $.50 share - with a long-term horizon, they could achieve a 2-4x MOIC.  There two positive intangibles to be aware of.  Firstly, EHL’s CEO resigned July 2013 -- this would have been after management privately rejected the Platinum bid and EHL’s share price/business prospects tanked.  EHL appointed a new CEO in October 2013.  New management may not be so reluctant to hit a bid.  Secondly, the AUD has weakened over 10% since Platinum’s reported bid.  This not helps EHL’s customers (making their exports more cost competitive), but it makes EHL cheaper to a U.S. private equity firm (like Platinum).

(3)  Trade closer to book value
--------------------------------------------------
The market may re-rate EHL, ascribing a premium to liquidation value, once the market realizes EHL is not imminently going to liquidate.  Aggressive asset sales/deleveraging - facilitated by reduced capex, asset sales, and asset re-location – will achieve this.