WHERE WILL KNIFE FALL NEXT?
Under the Radar took profits on RCR Tomlinson before it exploded almost doubling subscribers’ money. Find out how to avoid detonating contractors and why there are buying opportunities in the sector, in both the big and small cap ends.
The demise of RCR Tomlinson (RCR) must have sent shivers through every value fund manager in Australia. If one of the flagbearers, the reputable fund manager Allan Gray can lose its 5.3 per cent stake in RCR, where next will the falling knife land?
This week RCR went into administration because it couldn’t get bank finance, having raised $100 million from shareholders including Allan Gray less only three months ago, may have shocked, but is only one of a number of blow-ups this month that have hit the contracting industry. Others include the crane operator Boom Logistics (BOL), whose stock fell almost a third after a profit downgrade due to strike action, but has since partially recovered, shares the mining services stalwart Maca (MLD) got smacked 25 per cent due to increased labour costs, and of course, one of the giants of the sector, LendLease (LLC), fell 25 per cent after announcing cost blowouts in engineering contracts.
HOW DID IT COME TO THIS?
Before discussing whether any of these companies are worth buying (RCR excluded) it’s worth looking at how it came to this and how you can avoid owning an RCR at the wrong time.
The first thing to note is that the earnings of contractors are highly cyclical, which means they benefit from fast economic growth. One Under the Radar analyst pointed to the fact that these sorts of problems happen late in the cycle, which refers to the relatively long period of global economic growth post the financial crisis of 2008-9. Certainly a key to much of the pain being experienced by these companies isn’t on their ability to get work, which we don’t think will be a problem for the next one or two years at least, it’s their ability to get profitable work. Put another way, it’s their inability to keep costs down.
THE CONTRACTING BUSINESS IS TOUGH
If you are a contractor like RCR you are at the cutting edge, literally, because of the high fixed costs nature of the contracting business. This means that you are more vulnerable to the cycle. When the music stops, you can go broke, which is why “to catch a falling knife” is applicable to those investors like Allan Gray who subscribed to the $100 million rights issue RCR held in August, which was at a 64 per cent discount to its $2.80 share price prior to the capital raising.
CHASING GROWTH FOR GROWTH’S SAKE DOESN’T END WELL
But in my opinion, even more important is the folly of chasing growth for growth’s sake. You see it everywhere – just ask the banking executives hauled before the Royal Commission. Long-term watchers of the stock market know that management and investors become addicted to growth. A company’s focus has to be on profitable growth otherwise short-term gains often come with the cost of long-term pain. Addictions rarely end well and the stock market is no different, often destroying the very profits investors have made and eventually ending in losses.
Because of the analysts’ fixation on growth and the numbers in the profit and loss statement, they often ignored the cyclicality of those numbers and the potential for an economic downturn to cause big losses in profitability.
WHY THE BALANCE SHEET IS SO IMPORTANT, BUT IS OFTEN IGNORED
When looking at these stocks and working out whether they’re worth investing in, the best place to start is the balance sheet. In their fixation for growth that most broking analysts have, they often ignore this particular arm of the financial statements.
A good way to look at contractors is using the company’s book value, rather than its earnings to value the company. The book value simply it’s asset minus liabilities or net assets. This is typically more stable than the company’s earnings because it’s a balance sheet item.
A GLOBAL BUSINESS
LendLease might trade on a low price to book multiple after its big sell off due to write downs relating to cost blowouts in its engineering division, but that doesn’t mean it’s good value. In order to assess this we need to look at its future growth prospects. For a number of years now this business has been globally diversified and has a $71bn development pipeline. Once you factor that into the equation and this company looks great value. Buy the fear!
In relation to the crane operator Boom Logistics, the company is vulnerable with debt of $44 million, but it has reduced this debt from almost $90 million only four years ago. Also, management is turning its operations around and increasing its utilisation rates and hence producing positive cash flow. There are still be risks, but Boom at current levels is trading at almost half its net tangible assets. That’s cheap!
Like Boom, the mining and civil services contractor Maca is facing cost pressures from increasing wages, which is an inevitable impact of a tight labour market driven by a strong economy, which is actually a good thing. Besides having been around for a long time, Maca has some $63 million in cash on its balance sheet.
OPERATING LEVERAGE WORKS BOTH WAYS
Because of their high fixed cost base, these stocks have the operating leverage which can supercharge your portfolio’s returns. But as RCR shows, you have to be able to treat management optimism with a great deal of scepticism in order to profit.