MDI – A ridiculousy low PEG ratio

The rumour has it that when Danie Pretorius bought his first second hand raise bore rig in 1986, he was fixing it up at his home, but, as it was too large for his yard, it was protruding out onto the street of his Fochville suburb. 30 years later, Danie owns 53% of a R2.5bn company and Masterdrilling (MDI) is set to continue growing for years to come.

The company now owns 105 raiseboring rigs and is expanding into conventional exploration drilling as well as blind boring. Their fleet of raiseboring rigs is the largest in the world and their expertise and innovation in this niche industry is second to none.

In their recently announced results for the year 2016, MDI declared profits of R2.10/share and a maiden dividend of 30c. This puts the share on a Price Earnings multiple of 8.5 and a dividend yield of 1.7%. Most importantly though, earnings grew by 20%, after growing 30% in the September 2016 half yearly results and 31% in the 2015 financial year. As is often the case for these rapidly growing companies, we analysts can apply a PEG ratio, by dividing the PE multiple by the company’s growth. Generally, anything under 1 is considered excellent. For instance a company that is growing at 20% should trade at a PE of 20 (like Google parent Alphabet). MDI’s PEG of 0.43 is ridiculously cheap.

A more careful inspection of earnings, however, reveals that all of last year’s growth was derived from exchange rate benefits, against the backdrop of a difficult mining industry environment, the company actually stagnated in dollar terms. I work in the mining industry and the market is definitely showing signs of turning. MDI are brilliantly positioned for this increase in mining capex with their truly global presence. They have just established footprints in DRC, Tanzania and Sierra Leone to supplement their African platform in established mining jurisdiction such as Zambia and South Africa. When this is coupled with a strong presence in South America in the mining hubs of Brazil, Chile and Bolivia, an ongoing contract in the USA and a shareholding in Swedish Bergteamet Raiseboring Europe AB, it becomes clear just how well this company is positioned for the next upturn in the market.

With a cost base that is mostly in Rand, they should remain globally competitive and continue growing for years to come.

The use and application of the raiseboring and blindboring technologies is growing strongly. They are non-explosive excavation methods that are safer and cheaper than conventional drill & blast mining. Increasingly, their use is also growing outside of mining into infrastructure projects, such hydropower plants, tunnelling and storage.

Due to MDI’s unique global position in this growing niche market, it is difficult to compare it to a peer group. Redpath, is the world’s largest shaft sinking company. It is privately held by a German family holding company, ATM Holding, the same company that recently took a 25% stake in South Africa’s other shaft sinking champion, Murray & Roberts. Redpath is rumoured to be valued at $1.1bn, while M&R carries a valuation of R7.5bn, approximately 3 times the value of MDI.

Given MDI’s competitive advantages and growth profile, it may not be too far-fetched, to consider that this company could one day be the size of Murray & Roberts. They are managed by a driven individual, who has a large vested interest in the future performance of the business and continue to operate in a growing niche. If the mining industry turns upwards in the next few years, and the MDI multiple expands as the company continues to deliver, I am convinced that this company can easily increase in price by 2-3 times from the current level. MDI remains incredibly cheap.

ILU – A much better way to buy-to-let

Many affluent South Africans are firm believers in owning additional properties, which they rent out to tenants, the buy-to-let strategy. This is a solid strategy, which offers good long term returns at low risk, an understandable business model and has made a few people very wealthy.

I myself own a two-bedroom property in Centurion, which I purchased for R 640,000 two years ago. The monthly rent is R6200, but after I have deducted rates, taxes, agent’s fees and levies, I am left with R3700, an annual return of 6.9%. That is if the tenant pays, no repairs are required or any other unforeseen events occur.

Indluplace Properties (ILU) is a listed REIT (real estate investment trust) that owns 5,500 apartments and manages them on the shareholder’s behalf. Their properties are worth R2.3bn and they have 97% occupancy. At this scale their risk is diversified and maintenance is centralised. ILU paid a dividend of 93c in the last year, putting them on a yield of 8.9%, a full two percentage points higher than my buy-to-let property.

“But, Mr Business Musings”, you may argue, “you do not understand the purpose of buy-to-let! Have you considered: “

  • “My property is in a fantastic location and is sure to go up in value.”

ILU own bachelor, one and two bedroom apartments, which are 90% in Gauteng, particularly in the revitalising inner cities. I have previously explained how demographics are almost certain to positively affect property prices in this province. If the value of ILU’s properties goes up, so will the share price and the yield. If my view of the fundamentals of the property market changes, then I can sell my shares within a day. If I wanted to sell my property in Centurion, that would be a far more difficult and expensive undertaking.

  • “My rent goes up every year, my bond costs stay the same”

As rents go up, so will the funds that ILU has available for distribution. The costs of debt change for both you and ILU in line with interest rates. Although, it is likely the ILU – as a billion rand company – will get better interest rates than you.

  • “You are ignoring taxes in your assessment!”

Taxes are the same for rental income and dividends paid by REIT’s. Both are taxed at your marginal tax rate. You can offset your interest rate on your bond and your property expenses, but ILU is doing the same, before they pay out their remaining cash flow in dividends.

  • “You are forgetting the benefits of gearing!”

Indeed, this is the only good argument I have heard for buying your own rental property. A deposit of R100k means that if the property increases in value from R600k to R700k, you have doubled your investment. ILU is mostly ungeared, their debt is only 10% of assets. However, I do not regard this as a negative. I believe this offers them room for massive growth in shareholder returns. As their debt-to-equity ratio is increased, they will more closely approach this last benefit offered by buying your own property.

In fact, I am convinced that management is keeping their debt low in preparation for a juicy acquisition at current low property prices. In the forecast of the previous annual report:

“The board is confident that ample opportunities for acquisitions exists and that Indluplace will grow the portfolio substantially over the next few years notwithstanding the current financial climate”

It is therefore not surprising that they are currently trading under a cautionary announcement, pending the announcement of a transaction.

I never tire of taking joy from directors holding shares in the company, in this case 7.3%. Cornerstone and founding investor Arrowhead Properties hold 60% and are likely to provide strategic guidance and direction for the moment.

 

CIL – The good, the bad and the ugly

power-lines-504

The good

Electrification in Africa is a huge theme. The bulk of households in sub-Sahara Africa do not have access to electricity and, where it is available, it is poorly distributed and maintained or fluctuates wildly. More and more, these people will  demand access to electricity, as the ubiquitous availability of cellular phones has made them increasingly aware of the quality of living improvements that it can offer. At the same time, access will become more viable through the increasing development of Africa, the consumers’ rising purchasing power and the continuing decrease in the cost of renewable energy providing a viable alternative to more standard large scale technologies.

All of these trends play into the hands of the companies, who build and maintain the infrastructure that is required to distribute this electricity. Consolidated Infrastructure Group (CIL) has grown phenomenally over the last few years, as they have complimented their position as a market leader in South Africa with a large and growing business in a plethora of African countries. They are positioned for the growth that is certain to come in Africa and have increased their cash flow from operations at home by diversifying into the smart metering market through the acquisition of Conlog.

The company has strongly growing revenue, and EBITDA and a ballooning order book. With their latest earnings, CIL is trading on an approximate PE of 9. Furthermore, directors and associates hold 9% of the company, showing a vested interest from management in the long term performance of the business.

The bad

It may sound petty, but it always raises an internal warning signal, when a company does not make their financial results easily available. Rather than most other companies, CIL did not publish their results on SENS, rather they informed investors that they are available on the website. When attempting to find the results on the website, the link to the 2016 results pops out the 2015 result pdf file. Finally, after some search, I found the 2016 annual report.

Ohhh and also the company did not declare a dividend.

The ugly

A look at the financial results shows a possible explanation why the financials are so difficult to find and also why the company does not pay a dividend.

In the last year “amounts due from contract customers” increased by R1bn to a total of R3.7bn. To put that into perspective, the increase in receivables is more than the entire gross profit of the company in the last year, putting a severe strain on cash flow. These appear to be owed by various  sources and from various contracts. The company is trying to offset this by delaying their own ayables, but this will not be a sustainable solution.

R3.7bn is more than half the assets of the company. It is also more than the entire NAV of the company. R25/share in “amounts due from contract customers”, more than the current share price.

Of course, delayed contract payments of this nature and working capital management are part of operating in the construction industry, but increases of this size and exposure of this severity should warrant a few explanations from management. Unfortunately, none can be found in the annual report.

Conclusion

Due to this large exposure and increase in receivables, I am no longer comfortable being a shareholder in this business and have sold my shares. However, I remain very optimistic about the long term future of the electricity sector in Africa and am using ARB Holdings as my exposure into this theme.