All Values are given in Australian Dollar.

Like a few write-ups in the past few months (Emeco Holdings and Swick Mining Services), MacMahon Holdings is an Australian mining services company. The company does contract mining exclusively for Blue Chip mining companies. Some examples are BHP, Rio Tinto, Peabody Energy, Newcrest Mining, Anglogold Ashanti, Fortesque and Lafarge. The single non-blue chip mining company they currently have a long term contract with is  Erdenes Tavan Tolgoi, which is a Mongolian government backed company. Erdenes TT is currently the only contract of significant value where there are having payment issues with.

Although this is the mining industry, I see very little risk in any of the current contracts because of the blue chip nature of the mine owners, the long mine life of the operated mines and the long duration of the contracts (a lot of contracts go back at least 3-4 years and have recently been extended, and many of the newer contract wins are for a period of about 3 to 4 years). This gives MacMahon some certainty about future revenues.

Background

MacMahon Holdings is a 51 years old company. Until recently, it was a combination of a construction company and a contract mining company. You can find this layout in a few other Australian listed companies. The rationale behind it is that both sectors are related and complementary. They require a similar engineering background and equipment, but the contract mining sector is capital intensive, where the construction part is not so.

Last year MacMahon decided to dispose of the construction business because this subsidiary had been making heavy losses for 2 years (in 2011 and 2013) on the back of overruns on contracts. This move came at a bad time, considering the meltdown in the Australian mining sector was just starting.
On top of that, last year the company had a very dilutive capital raise (they raised a bit less than 80 million by issuing about 500 million shares at 16 cents a share on about 750 million outstanding shares) to offset the construction losses, and have the capacity to do the required capital investments on the back of 2 recent big contract wins in their mining subsidiary.

This capital raise was in line with a somewhat conservative nature of management. Just as the 2008-2009 crisis started to unfold, they again did a capital raise to strengthen the balance sheet, although in hindsight, this was not really necessary.

The business

Contract mining is a low margin, high capex business. The business is pretty mediocre and has very few barriers to entry. Despite this, the company has been able to have returns on equity of about 10-11% over a 14 year history, even in the years 2002-2003 which were not great for the commodities markets. I found this pretty important because this company made decent profits before the Australian mining boom in the last decade. This return on equity was however lower than many of it's peers in the contract mining space.

The mining business has also been pretty consistent in terms of profitability. This is related to the relatively simple nature of the business, where many contracts are either of a cost plus nature, or where they get paid a certain amount per mined tonne usually taking cost inflation into account. Of course, this is the mining business and unpaid claims and write-downs are pretty regular and are behind most of the variations in PBT margin over the last 15 years. This is somewhat mitigated by the blue-chip nature of MacMahon’s clients.

The investment thesis

The thesis is very similar to the recent Emeco Holdings writeup, but MacMahon has a few more levers to pull than Emeco.
MacMahon is valued at 0,375 times tangible book value, has an EV/EBITDA of about 1,5 and has a forward PE of between 3,5 and 5. These metrics make it really cheap.
The contract mining business has a contract backlog of 2,8 billion and aims for revenues of between 900 million to 1,2 billion for FY14. For FY 2015 they have contractually fixed revenues of at least 700 million with a potential upside of 100 million.

To see MacMahon as a going forward business is not unreasonable considering they have a tendering pipeline valued at 3 billion dollars, which is their highest ever. There is some uncertainty on this pipeline because contract awards have been deferred due to delays in the startup of most mine projects in Australia and margins will probably be lower on these tendered contracts.
As a going concern business MacMahon should be worth a slight premium to book value.
Even with all these points considered, I am also of the opinion that the boom days are over. Most of the giant low cost Australian Iron Ore mines have been developed (except for Roy Hill) and Australia is not the lowest cost producer for most of the other commodities (except for metallurgical coal). These facts could delay the startup of these projects for a later day when commodity prices have sufficiently recovered, which could take years.

While I consider this situation not impossible, there is also a worst case scenario. In this scenario, I would like to look at the similarities between MacMahon and Emeco Holdings (which was written up about a month ago).

MacMahon is in a better shape than Emeco. It has a net debt of 100 million, a debt to equity ratio of a bit more than 25%, has 100 million in cash, a working capital surplus and operationally should be a net cash generating company going forward because most of the capex for recent contract awards have been done in the last year and a half.
On top of that, the contract backlog should produce revenue certainty, and more importantly, cash-flow from operations for a few years to come. This gives them more time to dispose of their assets, which consist mostly of Earth-moving equipment. Like Emeco, MacMahon has been able to sell off these assets very close to book value over the years (usually within a 5% range around book value). Last half-year (from Jun-Dec 2013) they even booked a profit on the disposal of assets, something which Emeco had not been able to do. MacMahon’s CEO made clear during the latest conference call that they have surplus equipment which they are willing to sell, but they have the patience to wait for a decent price. This is a luxury which Emeco does not have.

The downturn in the mining sector in Australia created a lot of excess equipment which is now for sale and has caused for a supply-demand imbalance for 2nd hand Earth moving equipment. As Emeco has shown, during their last calendar year they had to sell this equipment for a 15-22% discount to book value.
When MacMahon will sell their equipment if they would wind down a part (or the whole) of the company, it will be more gradual after most of their mining contracts have expired, which will be a few years down the road. This should enable them to get a better price for their surplus equipment.
As a last point, we should not forget that MacMahon should be able to generate some profits on the contracts they currently have. The average PBT margin for MacMahon has been between 8 and 5% over the last decade. Even taking a conservative 3-4% after tax margin on the complete order book of 2,8 billion should net the company between 80-120 million in net profit. And that is excluding any of the short term work of about 100 million a year the company has received over the last few years related to mine development and extensions.

Management

Over the last half-year there has been an extensive management change. The company has a new CEO, CFO and a new Chairman of the board. Both the new CFO and Chairman have very solid industry credentials having served high positions in some of the better Australian mining services companies.
The new CEO was recruited internally, which I find a big plus. He has been working for the company for 8 years, as both the CFO and more recently as the COO, and had been the CFO of Woodside Petroleum before resigning due to job dissatisfaction.
The current CEO has about 1,5% of insider ownership (after buying his stake around december 2013) and the past CEO still has close to 3% of insider ownership. While this is not much, it means they have at least some skin in the game.

Returns

In making a valuating model I have centered this around the book value of the company. While the company currently has some other favorable metrics (a cash-flow yield of above 50%), these are more prone to fluctuations in this difficult operating environment. Another reason for using book value is that most of the equipment markets around the world have held up pretty good (except for Australia), but also because this was the way most of these mining services companies were valued prior to this downturn.
I believe the company should be valued in the market for a slight premium to the current book value, considering their backlog, management and the fact that it is profitable.
I have made a sensitivity analysis around the book value. Because the company made a return on equity for the last half year of about 5%, I do not think it is unreasonable that the company should be able to grow book value over the years executing on their contracts.


                                               current multiple to book                        holding period  
multiple to current book                      0,375          yearly return (3j)     yearly return (4j)         yearly return (5j)
                                       0,8                                             28,73%             20,86%                            16,36%
                                       0,9                                             33,89%             24,47%                            19,14%
                                       1                                                38,67%             27,79%                            21,67%
                                       1,1                                             43,15%             30,87%                            24,01%
                                       1,2                                             47,36%             33,75%                            26,19%
                                       1,3                                             51,35%             36,45%                            28,23%

                                       
Risks and uncertainties

The biggest risk is that management would be uncareful with capital allocation. While I assume that the odds of a complete wind down of the company are slim, I think they would not imprudently spend money on unluctrative contracts. Even in the event of this happening, the margin of safety is very large.

Other risks are related to the contracts they currently are servicing. Fortescue is by far their biggest customer and should make up nearly 30% of this year’s revenue and their share of revenue will increase in the coming years. They are also responsible for 53% of MacMahon’s Order Book. While their credit rating is not splendid, they are on the lower end of the iron ore cost curve, and recently started a serious deliveraging program. Any contractual disputes or changes with FMG could have a big impact on MacMahon.

There were also some ongoing discussions on the Erdenes Tavan Toloi mine (a giant Mongolian Metallurgical coal mine), but as of this year the contract was not a big part of MacMahon’s revenue. Because Endenes is contractually obliged to take over the equipment upon termination of the contract, this event can be more considered as upside optionality rather than downside optionality. MacMahon is also insured by a third party should Erdenes breach this contractual agreement.

Even with the trend by mining companies of taking mine exploitation inhouse, this has usually happened at the end of a mining contract (as happened recently with Orebody 18). This can also be a plus for MacMahon because in the past some mining companies have bought the contractor’s equipment following such a takeover.

Conclusion

The recent mining downturn had created many low valuations in this sector. Where some of these companies are cheap for a reason, MacMahon should provide enough protection even in the event of a massive downsizing of the business.

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When the panic in the mining services sector subsides, valuations should move closer to fair value.

 

Resolution of the Erdenes Tavan Tolgoi dispute

Returning cash to shareholders if business downsizes