Description

Metso – Short Recommendation

I am recommending a short position in Metso OYJ common stock (Bloomberg Ticker: MEO1V FH) currently trading at EUR 24.40 per share. Metso is a Helsiki based global supplier of process industry machinery and systems. Its two largest end markets are mining (55% of sales) and construction (18% of sales). Please refer to the company’s corporate website for a more detailed description of their business: www.metso.com

On July 29, 2012, gs0709 recommended Metso stock as an attractive short to play a peak in global mining capital expenditures. Please refer to his write up for background on the thesis which I believe continues to be valid. Since the initial write up in VIC, Metso has generated a positive total return of +6%  (negative 6% for the shorts) versus a +27% return for the BE500:IND (index of 500 most liquid European stocks). I believe right now is a very opportune time to revisit the idea as the stock has rallied around the spin off of Valmet, it’s pulp and paper business.

The company recently spun out its higher quality pulp and paper business, Valmet. In the weeks prior to the spin, Metso rallied almost 20% based on optimism around the potential restructuring of the legacy business. Management, presented its intention to attain aggressive long term profitability targets. Please see the January 9 SEB Enskilda Nordic Seminar on the company’s investor relations website for further details. However, I see room for significant downside in the next twelve to eighteen months as the thesis that gs0709 outlined in 2012 continues to play out and actually accelerates.

Although negative earnings revisions for Metso have been ongoing since the second half of 2011, I see the trend accelerating over the next twelve to eighteen months. My bottoms up analysis suggests that consensus earnings estimates are still 20%-40% too high for 2014 and 2015. While one should expect an expansion of multiples at the bottom of a cycle, Metso, at today’s valuation of 18-20x my 2015 estimates appears richly valued on an absolute and relative basis. In addition to cyclical headwinds, there is evidence that competition in Metso’s end markets is increasing, creating potential for secular pricing pressure down the road and a further de-rating of the stock.  The deterioration of certain balance sheet/cash flow items evident in the past couple of quarters also suggests that the company may be struggling to meet earnings. In my view, earnings revisions combined with a few points of multiple compression could generate 20-40% downside in the stock over the next twelve to eighteen months.

Large Exposure to Mining Capex in the Midst of a Downturn

• Post-spin, mining will account for 55% of Metso’s revenues.
• We just witnessed the largest mining capex cycle in modern history and we are still in the decline phase. From 1970 to 1981, mining capital expenditures grew by 155%, a compounded annual growth rate of 9%. That up cycle was followed by a two year, 46% peak-to-trough decline in expenditures. From 1983 to 1997, mining capital expenditures grew by 100%, a compounded annual growth rate of 5%. That up cycle was followed by a four year, 41% decline. From 2001 to 2012, we have been in an almost uninterrupted up cycle (2009 being the only down year) during which mining capital expenditures have more than quadrupled from USD 33 billion to USD 160 billion, a compounded annual growth rate of 15%.  We are still in the decline phase.
• Shareholder pressure and management turnover at mining companies following a period of value destruction are forcing large and small miners to reassess their approach to capital investment. Major metal markets are becoming over supplied after years of aggressive investment (coal, iron ore, copper, aluminum). Capital intensity of Chinese GDP is declining.
• Metso is still over-earning and the  Street continues to underestimate the impact of the expenditure cliff that could nearly halve Metso’s “normalized EPS.”
• Contrary to company guidance, global mining capital expenditures will continue to fall in 2014, 2015. Mining capex will potentially be ~50% lower in 2015/2016 relative to its peak. 

Negative Operating Trends and Negative Accounting Trends

• Orders at Metso have weakened and underlying margins have begun to show signs of pressure despite a positive mix shift towards services segment. The Street underestimates the negative impact this dynamic.  
• Restructuring charges will soak up future cash flow.
• Cash flow from operations has declined over the last couple of years and working capital has continued to expand despite a decline in backlog.
• Free cash flow has lagged earnings significantly.
• Net project receivables (receivables less customer advances) have increased relative to sales in recent quarters. The company’s exposure to customers with precarious finances (Northland Resources) has increased.
• Percentage of completion accounting, which accounts for 40% of revenues, provides management the opportunity to delay recognizing losses but collection problems ultimately will have to be recognized.
• Metso is a later stage supply-chain player versus companies such as Joy Global and Caterpillar. Therefore, the company has not yet borne the brunt of the decline in its end markets.

Increasing Competition Poses Long Term Secular Threat

• Metso’s core products (grinding mills, crushers, pumps, filters, conveyors, bulk material handling devices, etc) are fairly commoditized and facing increasing competition from emerging Asian competitors. This competition will result in greater pricing pressure both for original equipment as well as aftermarket supply chains.  Depending on the product set, Metso competes with CAT, JOY, FLSmidth, Outotec, Sandvik and other smaller peers.  Increasingly important, Metso and its Western peers also compete with a number of very aggressive Asian competitors like Sany, CITIC, LiuGong, Zoomlion, Longking. These emerging competitors are making an aggressive push into Metso’s market. In a time when miners are looking to cut costs, these new competitive products are gaining adoption.   There is evidence of customers being increasingly receptive to acquiring these  “similar or “good enough” products and parts at a discount.  As a result, the pricing and margin pressures will extend beyond the cyclical pressures.  
• Pricing pressure is underappreciated by analysts.  Field calls and commentary on the earnings calls of various equipment suppliers suggest that there is pricing pressure across both the OE and aftermarket supply chain.  Metso itself has discussed weakening aftermarket order trends.  Orders for aftermarket are beginning to fall and I believe that this will accelerate as the installed base shrinks. JOY’s aftermarket orders underperformance may be foreshadowing that of Metso. 
• I believe that Metso’s business is also more commoditized than most of its peers, and, as result, subject to more competition. Contrary to management guidance, pricing pressure will push ROIC lower versus companies like Atlas Copco that have more sustainable competitive positions.

Valuation & Pathway to Estimates Revision

• Consensus estimates appear high based on bottoms up modeling. I believe that for 2015 eps of  EUR 1.20 to 1.40 per share is realistic versus consensus of EUR  1.95 per share. Based on my estimates the stock trades at 16-19x 2015 earnings versus 12.5x consensus.
• I think the risk to the upside is fairly limited given elevated Street numbers, evidence of continued cyclical deterioration, and evidence of increasingly competitive markets
• I see 20-40% downside to a  price of  EUR 15-18 per share. I arrive at this price by applying a low to mid teens multiple to my earnings estimates.  I think that the long-term competitive pressures, should they begin to manifest themselves more clearly, could justify the low end of that range. However, , but given the ‘scarcity’ of European/Scandinavian industrial names, I do not assume much multiple compression beyond optical levels on current consensus estimates (which are too high and still project modest growth in FY2015). 
• The story should play out over the next reporting periods as orders, sales and margin levels, disappoint and analysts revise down numbers accordingly. Sign-posts will include backlog data, earnings releases, continued negative guidance from miners regarding capital expenditures(Rio, Vale, BHP, etc), signs of increased Chinese competition and pricing pressure in the mining equipment space (see Dec. 2013 Economist – “Digging for Victory” which coincides with my research findings), deteriorating order books and book to bill ratios at other mining equipment companies.   

Risks to short

• Activism – Cevian has been involved in the company for many years and continues to own 13% of the stock. They will continue to pressure management to reduce costs and unlock value wherever possible.
• Resilient aftermarket sales - Nearly half of Metso’s earnings come from aftermarket sales , which are a more sticky and less correlated to mining capex declines than the original equipment business.  While Metso and other equipment companies had initially argued that aftermarket sales should mirror production growth, this argument has not come to fruition judging by results at peers. Despite increased commodity production levels, several other equipment companies have cited declining aftermarket sales likely as a result of disinflation in mining equipment prices after a decade of excessive inflation.
• Restructuring - Part of the bull rests on the hope that a more focused management team, post spin off of Valmet, will be able to focus entirely on the mining business and extract significant cost savings. .  While I do not argue that there may be further restructuring opportunities and incorporate this into our numbers, a lot of the restructuring has already taken place as evidenced by the restructuring charges taken over the past couple of years. I believe that top line pressures will outweigh any potential progress from restructuring efforts, resulting in a significant shortfall in consensus numbers. As per company guidance, the current consensus already factors in gains from cost cutting and restructuring which have yet to be achieved.

Catalyst

• Negative backlog trends
• Negative earnings revisions
• Evidence of competitive pricing in end markets
• Evidence of weakness in after market sales
• Continued  balance sheet deterioration