|Shares Out. (in M):||76||P/E||6.3||0|
|Market Cap (in $M):||20||P/FCF||2.8||0|
|Net Debt (in $M):||2||EBIT||5||0|
I am recommending an investment in Mastermyne Group Limited (ASX: MYE). I have sized this is a small position which is part of a bucket of well-selected mine service companies in Australia.
Mastermye is a $20 mm market cap mining services company, focused primarily on the underground coking coal market in Australia. A recent acquisition, Diversified Mining Services (DMS), diversifies the company beyond underground coal to surface mining and port maintenance. Mastermyne currently operates in three segments: underground mining services, engineering and fabrication, and electrical and mechanical services. The biggest driver of the business is the underground segment which primarily focuses on services to operating mines that could generally be considered maintenance. The services business is more exposed to new mine construction and has really had just one banner year in 2013 where it worked on a large contract. Services include: roadway development, conveyor installation and maintenance, vent installation and maintenance, roadworks, drainage, equipment hire, labor provisioning, training, etc.
An investment in Mastermyne provides an opportunity to own, alongside significant insiders, a specialized mine service company at about 56% of tangible book value (adjusted for DMS transaction noted below) that is supported by a balance sheet allowing the company to survive in a currently depressed market and to take advantage of opportunities that emerge. While at a fraction of TBV, the business trades at perhaps 7x depressed earnings and provides a significant option value on improved fortunes of the Australian coal business which are naturally difficult to predict. To provide a frame of reference the shares peaked at about $2.50 and are now down 90% at this point.
Despite the potential of the thesis, there should be no illusions... Matermyne operates in a difficult business with large dominant customers that have significant bargaining power. It is a cyclical business. We may not be at the bottom of the cycle. The company is levered to China given that country’s consumption of metallurgical coal.
A smaller position size would be in-line with not over-allocating to this industry and adding the company to a small bucket of such names.
Why the Opportunity Exists
The mining business in Australia, and specifically coal, is under a great deal of stress. Prices for coal, and coking coal specifically, are at multi-year lows.
Sentiment in the mine services space is quite weak. A number of businesses trade at discounts to tangible book value and have been declining quite significantly over the last few months.
The large mining companies have been and are continuing to pressure suppliers for concessions. The service companies have little bargaining power. The burst of the mining boom has created much less work and excess capacity. Competition has become severe.
More specifically, the company recently provided a surprising trading update, in which it guided to a break even H1 and a likely weak H2. In the prior year the company netted $.8 mm in H1 and $2.2 mm in H2. It had expected overall EBITA margins (its preferred guidance number) to be up on 2014 just as late as the 2014 results presentation. The company began to spend on significant roadway tenders that have yet to materialize, which combined with poor utilization of owned equipment, has pressured earnings. The shares are now down about 60% over the last six weeks, propelled primarily by this announcement.
Management and Incentives
There is significant insider ownership. Co-founder Andrew Watts owns 11.26 mm shares worth $2.8 mm, Chairman Darren Hamblin owns 9.7 mm shares worth $2.4 mm and CEO Tony Caruso owns 1.4 mm shares worth $.35 mm. Combined the three own approximately 23 mm shares worth $5.5 mm. Obviously this was worth considerably more in the past. Relative to total compensation, those ownerships stakes are worth 17.1x, 44.4x and .8x, respectively.
Insiders have made changes in their ownership stakes over the years. Multiple insiders sold large blocks in 2012 at $2.40 and in 2013 at $1.40. Interestingly, insiders have been back in the market in 2014 buying shares. They’ve acquired collectively .858 mm shares for $.365 mm or $.425 per share.
Mastermyne is about to close on the $20 mm acquisition of Diversified Mining Services (DMS). The company has been looking for acquisitions over the last couple years as the coal business was weakening and was finally able to acquire the over-leveraged DMS. DMS was a services roll-up sponsored by private equity and it had sold another business prior to selling itself to Mastermyne. The purchase price consisted of $9.7 mm in Mastermyne shares at $.6217 per share and the discharge of $10.3 mm in DMS debt. At the time of announcement in late September, the company expected that with a restructuring and consolidation of the company, the DMS acquisition would add $5.5 mm in EBIT pro-forma for a full fiscal 2015. Subsequent weakness in the overall market and an update by DMS suggesting their business is trending below budget and the EBIT estimate seems somewhat optimistic at this point.
The company is levered primarily to underground coking coal operations. In fact, the entire business prior to the DMS acquisition was derived from this niche. It wasn’t therefore exposed to open-pit or thermal coal operations. DMS does bring some exposure to these areas and others. Underground coal does appear to be an attractive niche with some minimal barriers. An underground coal mine is a dangerous place to operate and reputation for safety given the potential for disaster is important.
Mastermyne has been taking market share over the last several years. They compete against companies like DeltaSBD Limited (ASX: DSB), which appears to be in a precarious financial position, and the mine division of WDS Limited (ASX: WDS). Mastermyne share of these three companies’ revenue has grown to 52.5% in 2014 from 30.9% in 2008 while the company’s share of EBITDA has increased from 25.0% in 2010 to 68.1% in 2014.
FCF is currently a fair bit in excess of net income. FCF in 2014 was approximately $7 mm excluding asset sales against $3 mm in net income. The company appears to aggressively depreciate equipment and new capital needs are not significant at the moment.
Given industrial relation contracts, a service company like Mastermyne is currently able to provide labor at a substantial savings for a mine relative to what they could achieve. The company estimates that advantage at about 20% currently, even accounting for Mastermyne’s profit.
Mastermyne completed a large service contract about 18 months ago. It has been carry a large equipment lease related to that completed contract. It is estimated at about $1 mm per year. That lease expires at the end of this December.
Valuation, Potential Return and Downside Protection
Valuation in this case is fairly imprecise. There is minimal visibility into actual earnings for any given year and an equity investor is reliant on the company delivering an acceptable ROE through the cycle by surviving through the cycle.
Pro-forma tangible book value (post DMS) is approximately $.45 per share. At $.25 the company is trading at about 56% of tangible book value.
The pro-forma market cap is $22.5 mm. FY ’14 earnings were $3 mm. If you were to assume a breakeven core Mastermyne business, add back $1 mm in excess lease costs that are ending, and a $2.5 mm contribution from the combination with DMS you could conceivably generate $3 mm pre-tax pro-forma in FY ’15. The shares would be trading at about 10x this depressed earnings level.
On a single year FCF basis and assuming depreciation continues to exceed capital needs by $3 mm in 2015, FCF could approach $5 mm. (And assuming earnings profile from immediately preceding bullet in write-up).
Since FY ’06 average pre-tax earnings (if you were to include $3 mm from FY ’15) are $9.7 mm. After-tax this would be nearly $7 mm.
Shares of Mastermyne traded as high as 1.25x TBV in September of this year. This was not exactly a robust mining environment. Even a return to tangible book value in 3 years would generate a double in the share price and an IRR of 26%.
A simple reprieve of the intense selling over the last several weeks following the most recent trading update could be a catalyst. The lower liquidity, trading update and industry sentiment pushed the shares down in a rapid fashion.
Award of roadway development tenders which would be large and utilize substantial pieces of owned equipment and drive substantial earnings.
While dividend payments may be minimal (if paid at all) this year, dividends have been a hallmark of the company’s capital allocation. On last year’s dividend for instance (which wasn’t a robust year) the shares would yield of 9.2% at current prices.
Further consolidation in the mine services space and elimination of excess capacity. Global private equity has begun to show interest in the space and there continues to be a number of businesses in various stages of distress. While I don’t necessarily see a sale of Mastermyne, it may continue to play a part in this industry restructure.
Metallurgical coal pricing is obviously the biggest risk. This price is likely driven by China given the percent of the commodity it is currently consuming.
The acquisition of DMS does not deliver the expected benefits upon consolidation. The company was purchased at a significant premium to tangible book value and relied upon estimates of sustainable earnings.
While Mastermyne had moved to a net cash position prior to the acquisition of DMS, the closing of the acquisition will result in net debt of approximately $10 mm. While the company will have approximately $40 mm in tangible equity post close, the net leverage position could lead to stress if the business takes another leg down.
A significant industrial accident damaging the reputation of the business.
§ A simple reprieve of the intense selling over the last several weeks following the most recent trading update could be a catalyst. The lower liquidity, trading update and industry sentiment pushed the shares down in a rapid fashion.
§ Award of roadway development tenders which would be large and utilize substantial pieces of owned equipment and drive substantial earnings.
§ While dividend payments may be minimal (if paid at all) this year, dividends have been a hallmark of the company’s capital allocation. On last year’s dividend for instance (which wasn’t a robust year) the shares would yield of 9.2% at current prices.
§ Further consolidation in the mine services space and elimination of excess capacity. Global private equity has begun to show interest in the space and there continues to be a number of businesses in various stages of distress. While I don’t necessarily see a sale of Mastermyne, it may continue to play a part in this industry restructure.