Insufficient Capital May Update

Insufficient Capital fell 5.67% over April, compared to the ASX300 gain of 1.18%. The top contributor was Stanmore Coal, while the largest detractor was Aurelia Metals. On a rolling 12-month basis, Insufficient Capital has significantly outperformed the ASX300.

Acrow Formwork and Scaffolding (ACF:ASX)
During May, Insufficient Capital entered a substantial position in Acrow. Despite sitting well outside our preferred investment field of the ASX300 (market capitalization is $56m), the firm satisfies our investing Ground Rules* and we believe it will be a long-term compounder for the fund. Acrow has seven locations Australia-wide and employs around 150 staff. Although Acrow was a terrible performer this month, we never profess an ability to pick the bottom in individual stocks. We prefer to spend time in good companies rather than attempt to time them.

Acrow has a strong focus on civil infrastructure projects such as the Harwood Bridge upgrade over the Clarence river (Client: NSW & Federal Governments) and the Civic Centre Flytower Façade Refurbishment (Client: City of Mount Gambier). With its focus on infrastructure, Acrow’s revenue is highly defensive and the company can grow countercyclically as infrastructure spending increases to stimulate the economy during downturns. We are excited about Acrow’s prospects due to a plethora of both state and federal election infrastructure commitments following recent elections:

Residential Construction Fears
It is difficult to find an Australian monthly investment newsletter which does not touch upon the woes of domestic residential construction. Residential construction work has declined 17.7% from its peak in mid-2016 (Business Insider). This could have explained why Acrow has fallen 40% over the last 6 months until we took a look at the proportion of Acrow’s revenue derived from residential construction.

In fact, only 12% of Acrow’s revenue is linked to residential construction. Furthermore, revenue derived from residential construction grew from $3.7m in 2HY18 to $4.2m in 1HY19. At Insufficient Capital, we are always grateful for fear (in this case, regarding residential construction) because of the opportunities that often arise from it.

Natform
Natform was acquired by Acrow effective September 1, 2018 for around 2X trailing 12 month EBITDA of $3.8m. Management is pleased with the integration. It is clear that there are strong synergies between the two businesses. Natform recently won its first Victorian contract for a few years with some help from Acrow. On the flipside, Acrow is targeting larger players in NSW formwork through Natform connections. Management also estimates that around half of Natform’s current job pipeline have a client connection to Acrow with the potential for an integrated product offering.

Management has stated that it is open to further acquisitions along with organic growth. We support this trajectory (but will analyse future potential acquisitions as they arise). We see value in Acrow if the firm continues to purchase businesses with synergies at low multiples of EBITDA. These will likely be revalued by the market at Acrow’s EBITDA multiple (currently 3.9X), effectively increasing the market value of the acquisitions. During 1HY19, Acrow made operating cash profit of $5.5m. Debt currently stands at $2.5m (the company has a $15m Westpac facility). At this late point in the business cycle, we would prefer Acrow fund acquisitions through free cashflow rather than through the facility.

Acrow’s roll up strategy is reminiscent of Greencross (GXL:ASX), an operator of vet clinics and pet stores throughout Australia which was recently bought out and delisted. Greencross similarly purchased businesses at low multiples (family-owned pet stores, private vet clinics etc), the cashflows of which were then valued at Greencross’ higher market-applied multiple. This proved to be very lucrative for investors. Of course, roll up strategy alone does not add any value. However, Acrow has indicated that its acquisitions should result in strategic synergies, pulling out pooled costs and promoting integrated product offerings.

Margin Growth
Acrow has achieved a remarkable improvement in EBITDA margin over the last 4 years due to its extensive range of formwork and scaffolding solutions, as well as superior overall service. Acrow is also introducing in-house engineering expertise to increase its service quality and product offering.

Valuation
Acrow is valued as if it is highly leveraged to Australia’s residential construction headwinds. The firm has a 6/2019E free cashflow yield over 20% with estimated double-digit earnings growth over the next two years. A PEG ratio (PE ratio divided by forecast EPS growth) of around 1 is generally viewed as reasonable, while high quality companies or those with defensive cashflows often have a ratio over 1. In comparison, Acrow’s PEG ratio is around 0.5 – an opportunity in a fearful market.

Yield
At Insufficient Capital, we do not particularly care for a dividend yield and almost always prefer our holdings invest their capital rather than return it to shareholders. If suitable investments are unavailable, we would generally prefer our holdings to engage in share buybacks rather than pay a dividend so as to marginally increase our ownership of the company over time.

However, if a holding offers a dividend reinvestment plan (DRIP) at a discount to its recent share price, we will take it up 99% of the time according to Ground Rule* #9. In Acrow’s case, the DRIP is at a 2.5% discount. The annual 6.3% yield represents a very low payout ratio to allow for dividend increases over time (we plan on reinvesting all dividends with the DRIP).

Cooper Energy (COE:ASX)
Cooper is a position which has nearly played out – a great example of a typical investment for the fund. Cooper generates revenue from the discovery, commercialisation and sale of gas to south-east Australia and low-cost Cooper Basin oil production. The company currently produces around 6PJ of gas per annum from the Otway Basin (mostly from the Casino Henry project).

Sole
Cooper purchased the ‘Sole’ gas project from Santos on 1 Jan 2017, and in late 2017 completed a $400m financing round involving $135m of equity and $265m debt, from ANZ bank and Natixis. The Sole gas field will supply 24PJ of gas per annum from June 2019 and has a growing portfolio of take-or-pay gas supply contracts, with customers including AGL Energy, Alinta Energy, Energy Australia and O-I Australia. These contracts reduce Cooper’s exposure to future gas price volatility (although we expect gas prices to increase, we still prefer to reduce exposure to commodity price risk). The project was 98% complete as at 31 March 2019 with capital expenditure incurred on the project to that date by the company totalling $314m. Below represents the increase from 6PJ (at Casino Henry) in 2019 to around 30PJ (upon commencement at Sole) throughout the 2020s.

Manta
There is also considerable upside with the development of Cooper’s Manta project which would nearly double production from FY2024. Although there would be financing costs accrued, the lion’s share of value would accrue to existing shareholders.

Domestic Gas Pricing
As gas prices are higher overseas, there is likely to be a shortage in the populous eastern states. Most gas is converted from coal seam gas and exported as LNG. At the time of project approval, the government rejected proposals that mandated a proportion of gas to be sold domestically. Cheap gas produced in Victoria is now being diverted to Queensland, where it is sold at a premium offshore. Currently, two thirds of gas produced is sold offshore. There is limited pipeline competition which adds further barriers to a competitive local gas market. This supports domestic gas prices with demand far outstripping supply. Even though Cooper is protected from gas price risk by its take-or-pay contracts over the majority of future production, it is a pleasant bonus that prices for uncontracted gas are supported by a strong imbalance between demand and supply.

Valuation
When we entered the position, Cooper had a market capitalisation of $470m and a significant cash position. This cash has now been depleted to finance the development of Sole while the market capitalisation has risen to $867m. 2020 EBITDA is forecast to be $178m (up from $37m in 2019). At purchase, Cooper had a 2020 forward EV/EBITDA of under 2X. This multiple has since risen to 4.8X.

COE:AU

Since Cooper will likely continue to achieve EBITDA of around $180m throughout most of the 2020s (excluding any potential contribution from Manta), we expect the market to value Cooper at a utility-like 8-10X EBITDA, which would imply a further 1.7-2X increase in value. Few investors are willing to invest on three-five-year time frames for future earnings potential. Some examples of comparable past investment opportunities would be Beach Energy and Oil Search pre-production. Insufficient Capital took on Cooper’s development risk and has been rewarded, however we believe there will be further rewards for investors who wait until the market fully appreciates annuity-style earnings. We will review and potentially exit the position once earnings begin to flow from Sole later in 2019.

A Quip from One of the Greats
“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative” (Benjamin Graham – The Intelligent Investor).

When reviewing our investments in Cooper and Acrow, Graham’s emphasis on the conditions for investment over speculation came to mind. When investing, we look at the business qualitatively before estimating future cashflows and then discounting them. Short-term fluctuations in valuation are irrelevant to our investment style.

We are confident in the long-term safety of Acrow as infrastructure spending grows with the Australian economy, while the firm’s valuation at a low multiple of cashflows supports an (hopefully) adequate return. Although it is generally risky to expose oneself to the Australian economy, we believe Acrow’s downside risks are on balance outweighed by the upside potential presented by a low valuation.

If subscribers would like further details on Acrow Formwork and Cooper Energy, we are more than happy to answer any questions.

Kind Regards,
Insufficient Capital

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