Strat­egy: Greg Hoff­man A po­ten­tial turn­around story

Fickle in­vestor sen­ti­ment can lead to great op­por­tu­ni­ties, as shown by this po­ten­tial turn­around story

Money Magazine Australia - - CONTENTS - GREG HOFF­MAN

‘You take the blue pill, the story ends. You wake up in your bed and be­lieve what­ever you want to be­lieve,” Mor­pheus tells Neo in The Ma­trix. “You take the red pill, you stay in Won­der­land, and I show you how deep the rab­bit hole goes.”

In­vest­ing in turn­around stocks can be like that. You can take the blue pill by avoid­ing them al­to­gether. Or you can take the red pill and know that there’s a fair chance of a gut-wrench­ing roller-coaster ride for the busi­ness and, al­most cer­tainly, the share price.

Mor­pheus’s “Won­der­land” might not be the ideal de­scrip­tion of this type of in­vest­ing but the “rab­bit hole” anal­ogy is a good one. In this col­umn I’d like to take you into the turn­around stock rab­bit hole us­ing the ex­am­ple of Ma­trix Com­pos­ites & Engi­neer­ing (ASX: MCE). Let’s see how deep it goes.

Cru­cial in­fra­struc­ture

Ma­trix is a spe­cial­ist man­u­fac­turer of riser buoy­ancy sys­tems. “Ris­ers” are large tubes used in off­shore drilling to con­nect the drill to a surface fa­cil­ity (a plat­form or ves­sel). Ma­trix’s buoy­ancy prod­ucts at­tach to ris­ers to keep them sta­ble un­der wa­ter, which is as chal­leng­ing as it is cru­cial to a deep­wa­ter drilling op­er­a­tion.

The com­pany was founded in 1982 and listed on the ASX in late 2009. It be­came a dar­ling stock dur­ing the re­sources boom. From its $1 float price the stock soared to a high of $9.88 in 2011 as many in­vestors mis­took a cycli­cal up­turn for a more per­ma­nent kind of growth. Its val­u­a­tion moved from $64 mil­lion at the float to $721 mil­lion at its peak – a ridicu­lous fig­ure for a niche manufacturing busi­ness like this.

The stock price is now down 95% from its dizzy­ing heights and I be­lieve to­day’s val­u­a­tion is ex­tra­or­di­nary in the other direction. In­vestors are now be­hav­ing as

if Ma­trix is a per­ma­nently mar­ginal busi­ness. They may be right. But if they’re wrong, to­day’s buy­ers have a good shot at mak­ing mul­ti­ples of their money over the next five years.

The stark change in at­ti­tude can be quan­ti­fied by con­sid­er­ing the price in re­la­tion to the bal­ance sheet. At the $1 per share float price, in­vestors were pay­ing $64 mil­lion for a busi­ness with just $26 mil­lion of net tan­gi­ble as­sets. At 45¢ per share (at the time of writ­ing), in­vestors are valu­ing Ma­trix at just $42 mil­lion while its net tan­gi­ble as­sets stand at $115 mil­lion.

In other words, you’re pay­ing one third less and get­ting more than quadru­ple the hard as­sets that 2009’s float in­vestor was. In­stead of pay­ing 2.5 times net tan­gi­ble as­sets, you’re now re­ceiv­ing a mouth­wa­ter­ing 63% dis­count.

If Ma­trix can achieve a mod­est 4% re­turn af­ter tax on these as­sets, then that would im­ply a profit of close to $5 mil­lion. That would equate to an at­trac­tive price-earn­ings ra­tio (PER) of eight – to­day’s val­u­a­tion of $42 mil­lion di­vided by the av­er­age profit of $5 mil­lion.

That’s around half the val­u­a­tion level of many busi­nesses on the mar­ket to­day and strikes me as at­trac­tive. But it would be­come a down­right steal if the oil price were to im­prove and take ac­tiv­ity in the off­shore drilling in­dus­try with it.

In the past fi­nan­cial year, Ma­trix achieved rev­enue of $32 mil­lion. Just three years ago in 2014, the fig­ure was more than $158 mil­lion, al­most five times as much. This shows both the dan­ger and supercharged re­cov­ery po­ten­tial in­her­ent in such a cycli­cal in­dus­try.

Imag­ine a world where in 2020-21 the oil price re­turns to $US80 or more and Ma­trix’s rev­enue im­proves to, say, $100 mil­lion (still only two-thirds of 2014’s peak). Un­der those con­di­tions, the com­pany could eas­ily make $8 mil­lion in profit, or 8.5¢ a share. That would be a PER of just five at to­day’s share price. And even if the com­pany paid out only half of this as a div­i­dend, to­day’s buyer would en­joy a fully franked re­turn of 10%.

Un­der such cir­cum­stances, I’d ex­pect the price to be north of $1 a share, for a cap­i­tal gain of more than 100% from to­day’s level. That all sounds good but what are the risks that could turn this in­vest­ment into a dud?

Oil price dan­ger

The clear and present dan­ger is the oil price. Hav­ing fallen from more than $US100 a bar­rel in 2014 to be­low $US30 in Fe­bru­ary this year, it’s en­tirely pos­si­ble that it could fall again. That would keep ac­tiv­ity in Ma­trix’s key mar­kets sub­dued and per­haps re­sult in mod­est an­nual losses rather than big prof­its from the core busi­ness.

Other risks are that man­age­ment may mis­man­age a big con­tract, or a big client may fail to pay. Man­age­ment might also make some kind of ac­qui­si­tion that could turn sour. But these were all risks when the share price was $9.88. And they will be risks in three or four years, too. At least to­day we are be­ing com­pen­sated with ap­pro­pri­ate po­ten­tial re­ward for tak­ing them on.

Com­fort in cash

While rev­enue has fallen might­ily from 2014’s boom­time peak, the bal­ance sheet is much stronger to­day. At that time Ma­trix car­ried $16.7 mil­lion of debt off­set by $19.5 mil­lion of cash, giv­ing a “net cash” po­si­tion of $2.8 mil­lion. To­day the net cash fig­ure stands at $14 mil­lion. That’s more than one third of the $42 mil­lion to­tal val­u­a­tion we’re be­ing asked to pay to­day.

Apart from mak­ing the stock even cheaper than it might first ap­pear, that cash gives man­age­ment ev­ery chance of sur­viv­ing the cur­rent sav­age in­dus­try down­turn and pop­ping out the other side with a lean cost base ready to profit hand­somely from the next cycli­cal up­turn.

An­other way to win

There is an­other way things could work out well from here, even if the oil price doesn’t rise. And that’s through in­no­va­tion. Ma­trix has re­cently de­vel­oped sev­eral new prod­ucts for the oil and gas in­dus­try and seems to be kick­ing a few early goals.

It has also de­vel­oped prod­ucts for new mar­kets. One of these in­cludes “per­for­mance chem­i­cals”, en­com­pass­ing epoxy resins and a com­pos­ite ag­gre­gate that re­duces con­crete den­si­ties by up to 30% with­out com­pro­mis­ing the strength of tra­di­tional con­crete.

“Per­for­mance ma­te­ri­als” are an­other new mar­ket seg­ment in which Ma­trix has re­ceived two or­ders for its Ki­net­ica en­ergy-ab­sorb­ing light­weight foam. This prod­uct has ap­pli­ca­tions in both surface and un­der­ground min­ing as well as in the civil and marine sec­tors.

To­day’s buyer is get­ting the po­ten­tial of these new prod­ucts for free, not to men­tion all of the re­search and de­vel­op­ment ex­pen­di­ture that has gone into them so far. It’s a nice free op­tion that adds great po­ten­tial.

Any­one ven­tur­ing down this par­tic­u­lar turn­around rab­bit hole should pre­pare for a few nail-bit­ing episodes along the way and the chance of a nasty loss. But, per­son­ally, I’m set­tled in with my pop­corn in hand.

It would be­come a down­right steal if the oil price were to im­prove

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