Description

Raise your hand if you’ve done well in coal related investments over the last few years.

Why is no one raising their hands? 

I’ll tell you why – because it’s been a bloodbath.  But as Barron Rothschild is credited with saying after the Battle of Waterloo “the time to buy is when there’s blood in the streets.”  In this case – the original full quote is more applicable to myself “Buy when there's blood in the streets, even if the blood is your own.”

One of the coal names which seems like an attractive risk/reward is Sedgman.  They are very prominent in their niche of mineral processing plants operating in two segments: EPC and Facilities/Operations. 

Sedgman’s EPC business works with miners to design and build mineral processing plant for new mines and the expansion of existing mines.  It is highly specialized, largely dealing with coal handling and preparation plants but also with other base/precious metals processing assets as well.  The services are provided globally but in reality the vast majority of the revenue is based in Australia.

What is a coal handling and preparation plant?  In a nutshell coal preparation involves washing and crushing coal, putting it in a big pile, and getting it ready to ship to China (railroad to port).  These guys engineer the facilities that handle that process.  Metals processing plants basically involve extracting valuable minerals from the dirt out of the pit which is a complex and industrial scale operation.  These guys design/build both types of facilities.

Sedgman’s Facilities/Operations business provides management/labor for the above mentioned processing plants in operating mines.  The nice thing about this is that it is much more production focused vs. new development which is generally more shielded in the current environment.  The bad news is that this type of service is able to be brought in house by the miners who are very seriously trimming costs and extremely tough on contractor pricing in the current environment. 

If anyone ever looked at the core KHD business (cement plant EPC) back before it went all crazy, this is sort of like that except they also own and operate parts of those cement plants as an ancillary business.

Valuation:

The company has net cash of 78m.  That means that the EV of the business is about $45m.  The balance sheet is very very clean.  So what has and will the business earn?

I think that the Operations segment can produce EBITDA of approximately $15-20m (they did EBITDA of about ~13m in the half but I expect margins to come under pressure as and if the contracts are renewed). 

It seems reasonable to expect that the EPC segment, which is currently running EBITDA negative in a pretty material way, will decrease its costs to either achieve a flat or slightly positive operating contribution.  During the first half, as customers kept pushing back but not cancelling projects, Sedgman retained EPC staff in hope of booking those jobs.  This under-utilized a fixed cost engineering base and seriously depressed profits.  Going forward, the utilization levels of staff should normalize in line with the adjusted level of business in a way which enables Sedgman to earn some return on its collective expertise as a niche EPC (or at least breakeven).  There is a lot of room for improvement in this segment (headline EBITDA for the segment in the first half was -$15m).

 Based on just the Facilities/Operations level of segment EBITDA, Sedgman trades quite cheap (~3x EBITDA).  If EPC can contribute a few million that helps, but if EPC can get back to a ~20-30m+ EBITDA contribution, the stock will likely be a home run.

There is real upside to a recovery in the sector and Sedgman will almost certainly be a survivor.  In 2012 this business did EBITDA of $66m.  The current EV is ~$45m and the market cap is ~$125m.  Will it ever get back to those types of earnings levels?  Realistically it could take a long time if it ever returns to those levels at all – mining is a cyclical business and thermal coal is in a tough spot right now.  My personal belief is that this is just another cycle in a cyclical industry and a good time to pick up dominant capital light niche businesses trading near cash and below TBV. 

The company is guiding for an improved second half of the year as they’ve been working to get the costs of the business in line with the smaller order book.  Guidance for FY 14 are for a profit of about ~$9m which is inclusive of a H1 loss of ~$7m.  Including ~$17m of D&A that’s a very healthy level of EBITDA at this EV.  This guidance includes some gain on sales of non-core assets.  But basically I think this business can re-size itself to remain profitable through the downturn as it waits to get out the other end of the tunnel. 

One big risk in this investment is that they’ll do something stupid with the cash.  They have said that they will focus on M&A as a strategy and they tried buy something a year ago but the deal didn’t go through.  Somewhat counteracting that very material risk of acquisition is the fact that it’s a buyers’ market, and while you’d normally be worried about talent walking out the door post acquisition today there is really nowhere for talent to walk to.  Those factors by no means turn the negative into a positive but it is something to think about when weighing that risk.  The CEO just announced that he will be retiring at the end of June and this is also a risk.

One positive factor is Russell Kempnich, a founding partner of Sedgman and the Chairman, who still owns about 16m shares of the company.  This was worth ~$32m a few years ago and is now worth ~$8m.  He should not want to risk the business in a material way and should try to steward value in a logical way.  Leighton Holdings owns ~1/3 of the stock which prevents an activist moving in and forcing a sale or slashing costs.  Not all of Leighton’s cornerstone shareholdings have done well but ultimately I don’t think this will be much of a determining factor in the investment.  The stock did not suffer a material discount when the coal market was healthier and the stock is down from the ~$2 range about 2 years ago to its current 57c with much more cash on the books.

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