Strategy: Greg Hoffman A potential turnaround story

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

‘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