One for the Watchlist – Elders Ltd.

For the past few months, I’ve been watching with interest as an attempted business turnaround takes place in Australia. The company in question is Elders Ltd., a venerated agrobusiness that has fallen on hard times. Elders provides a suite of services to Australia’s rural wool and beef industries and farmers, including animal feed, wool trading, live export, and financial services. Elders’ lengthy history began in 1839, when Alexander Lang Elder traveled from Scotland to the new colony of Australia to expand his family’s merchant empire. The business took off, and over the next several decades Elders expanded into mining, wool trading, banking, brewing and other businesses. Elders underwent multiple restructurings, ownership changes and name changes, but finally returned to the public markets in 1993. Elders spent the 1990s and 2000s expanding some divisions and divesting others, but generally growing its balance sheet and taking on debt in the process.

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The Problem

The financial crisis hit Elders hard. Elders had invested heavily in its forestry operations for years, only to record hundreds of millions in writedowns. The company’s automotive assets began to bleed red ink as global demand for autos crashed. The company’s debt load threatened to drag it into bankruptcy, so in 2010 Elders proceeded to raise $500 million in equity, using the proceeds to pay down debt. Hopes that the restructuring would restore Elders to profitability were soon dashed. The years 2011 and 2012 saw the company report a  further $456 million in losses. Elders’ problems ran far beyond the balance sheet. The company had become a bloated, unwieldy conglomerate with entirely too many lines of business and too little accountability among them.  In 2012, the company’s marquee rural services unit earned an EBIT margin of only 1.6%. Forestry continued to produce losses and automotive limped along. The only bright spots were Elders’ equity investments in various insurance and banking companies.

From June, 2007 to October, 2012, Elders stock plunged 99%. What was once a vibrant company with revenues in the billions was now struggling for life as losses continued and the debt load remained unsustainably high.

Elders began divesting its forestry operations in 2011, and announced it would also divest its automotive holdings. In October, 2012, the company announced it would begin preparations for the sale of its rural services unit. It looked as if a very old business, once an Australian institution, would see itself parceled off to other firms, a victim of over-leverage and poor management.

The Plan

Ultimately, the sale of the rural services business was not to occur. Shareholder dissatisfaction reached a fever pitch, resulting in new management being installed in April, 2014. New CEO Mark Allison has extensive experience in agriculture, and revealed plans to return Elders to an agricultural pure play by selling off remaining non-core investments and focusing on increasing profitability in the rural services unit, with a focus on high-margin, asset-light businesses.

Elders has spent most of 2014 selling off remaining non-core assets (forestry, real estate, feedlots, and many other small operations) and applying the proceeds to reducing its term debt. Earlier this month, the company announced the final steps in this process: an equity raise via a share placement and rights issue, and a new debt package. As a result, Elders will have no term debt for the first time in decades, and will finally be able to focus on profitability and growth rather than survival.

Elders’ new management team has released detailed plans to increase profitability, and hopes to nearly triple EBIT by 2017. Before looking at those plans, let’s take a look at Elders’ new capital structure. Following the share placement and rights issue, Elders has 837.2 million shares on issue. At todays’ price of $0.175, that’s a market capitalization of $146.5 million. Elders also has a class of “hybrid equity” outstanding. This is essentially floating-rate non-cumulative preferred stock. Dividends have been suspended since 2009, and Elders will have to pay 12 months of delinquent distributions before it can declare dividends on common shares. Elders has $150 million par value of hybrid equity shares outstanding, and they currently trade at 55% of par. Following the equity raise, Elders has $21 million in net term debt. However, the company just closed on the sale of its 50% interest in AWH Pty Ltd. for $32.4 million in cash. Finally, Elders’ new banking facility provides up to $308 million in working capital financing, of which $145 million will be drawn.

Elders’ new capital structure and enterprise value look like this:

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In connection with its capital raising, Elders’ new management team released a detailed presentation outlining they steps they will take to increase profits and reduce capital requirements. Elders new focus will be on its highest-margin, most profitable business lines. Below are a few selected slides from recent presentations. The first two contrast Elders’ current lines of business with where the firm will now position itself.

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Achieving EBIT of $60 million and a return on capital of 20% by 2017 will require a mixture of improved sales margins and reduced corporate costs. Elders has set out its specific initiatives in all its business areas that it believes will help achieve these goals. The entire presentation is worth a read and can be found here.

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In my view, Elders’ decision to return to its strengths is a good one. Elders has been a constant presence in many of the rural communities that it serves for generations, and the brand recognition and relationships that come with that kind of longevity carry value. The company’s long experiment in empire-building has rightly come to an end with the company barely surviving the venture. Rebuilding Elders’ profitability requires a return to the company’s roots in serving Australia’s large agricultural sector in rural communities.

The Outcome

If Elders is successful in growing EBIT to the $60 million target, the returns to shareholders could be substantial. For 2014, the company has guided for pre-items EBIT of $23-28 million. At the mid-point, Elders trades at 14.2x 2014 adjusted EBIT. The company trades at only 6.0x its 2017 EBIT target.

Elders hasn’t revealed the cost of its working capital financing (that I can find) so I’ll use an estimate of the 1 year Australian government bond rate of 2.59% plus a 2% spread. I’ll also assume that Elders increases the draw on its working capital facility 5% annually, as sales increase. For the hybrid capital securities with a rate of the ten year swap rate plus 4.7%, I’ll use an estimate of 8.56%. Note that the hybrids cost is an after-tax expense, with Elders passing on franking credits to the holders. Assuming Elders can meet its 2017 EBIT goal in exactly three years, let’s estimate profits at that point.

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If Elders achieves its goals, it stands a chance of earning close to $24 million annually for shareholders. This is slightly misleading, however, as Elders will not likely be a taxpayer for quite some time. The company has accumulated deferred tax assets totaling $255.9 million. A simplistic way of valuing these assets is to assume they are used up linearly over 10 years, beginning in 2017. Even at a high discount rate of 11.56% (the hybrid capital cost +3%) this yields a present value of $44.2 million.

Elders’ 2017 value under all these assumptions depends on the multiple assigned by the market to the company’s pro forma earnings, but it’s not hard to arrive at a value much higher than today’s, even using modest multiples. The chart below shows Elders’s prices per share and three year compounded returns at various pro forma earnings multiples, including the present value of the tax assets.

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In reality all that matters is whether or not Elders can successfully achieve the goals it has laid out. If they do, the company will stop being valued as a distressed equity and will begin to be valued on an earnings/cash flow basis, and the share price will rapidly appreciate to some multiple of anticipated future profits. The chart above is mostly intended to illustrate what the magnitude of that appreciation could be based on various extremely uncertain scenarios that include a lot of my guesswork and crystal ball gazing.

On the other hand, if Elders’ new management team fails to make progress and investors lose hope, Elders shares will be in trouble as investors begin to contemplate yet more restructurings, write-downs and management turnover. Given the company’s troubled history, investors will understandably show little patience and won’t hesitate to punish the stock price if management’s confidence proves unwarranted.

For those inclined to take a flyer on a successful Elders turnaround, the hybrid capital securities are also an interesting bet. Management has guided for no distributions for at least a while as the company dedicates capital to rebuilding and re-positioning. However, at some point common shareholders will demand a dividend, and hybrid capital holdings will receive a year’s worth of skipped distributions. If the arrears payments equal roughly 8.56% of par, distributions take three years to resume and the securities trade at par when they do, investors buying at today’s 55% of par will earn a total return of 97.4% and a compounded return of 25.4%. That’s competitive with the equity on a risk-adjusted basis. Given the uncertainly of Elders’ ultimate turnaround, perhaps investing slightly senior to the common stock is wise.

Personally, I require more evidence of progress before giving Elders serious consideration as an investment. Though its short-term financial troubles have been assuaged by the capital raise, the company faces a difficult task in restoring its profitability and expanding its margins. Even if the next financial report’s numbers look good and the stock pops, there will be plenty of time to buy in before the potential returns lose their attractiveness. At least for now, Elders remains one for the watchlist.

Alluvial Capital Management, LLC does not hold shares of Elders Ltd.  for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

 

Paul Mueller Company’s Ongoing Recovery – MUEL

A while back I wrote a post on Paul Mueller Company in which I highlighted the company’s promising improvements in profits and margins but expressed reservations about the company’s high financial leverage and large pension deficit. Ultimately, I decided the balance sheet issues were troubling enough to keep me watching from the sideline. Eighteen months later, the results are in.  Anyone who had disagreed with my assessment and bought shares is sitting on a whopping gain. From the end of April 2013 to the present, Paul Mueller shares rose 190% from $18.00 to $52.25.

The big move in Paul Mueller Company’s stock is due to the combination of vastly improved earnings and a de-risked balance sheet. At the time of my original post, I had pegged Paul Mueller’s adjusted 2012 operating income at $5.9 million. Since then the company has made great strides, growing trailing twelve month revenues by 7.5% to $193 million and nearly tripling operating income to $15.4 million. No need for adjustments either, as the severance expenses that depressed the company’s 2012 EBIT are in the rear-view mirror.

Improved profits aside, the company’s leverage has declined meaningfully. Total debt has been slashed by a third, falling from $34.2 million at the end of 2012 to $22.9 million as of June 30, 2014. The reduction was funded entirely through free cash flow, but not by sweating the company’s assets; capital expenditures have tracked with depreciation. The company’s pension deficit remains material, though it has also declined 40% since 2012. The decline is mainly due to strong appreciation in the pension plan’s equity investments. The expected return on the plan assets was held steady at 7.25% from 2012 to the present, though the discount rate on plan obligations was increased from 4.48% to 5.34%. (Increasing a pension plan’s discount rate results in lower present value of future payouts. Changing a discount rate is a totally legitimate response to changing long-term interest rates, but aggressive companies have been known to choose a higher discount rate in order to minimize reported pension deficits.)

Back, for a moment, to Paul Mueller’s greatly improved results. Recently installed CEO David Moore has made several comments about focusing on bringing each business segment into the black and making the heads of individual business lines responsible for results for the first time. The company has also implemented “open book management,” a concept designed to increase transparency, improve management/employee relations and help employees see how their individual contributions result in increased profits and their own rewards. In the 2013 annual report, Moore specifically mentioned the head of each business segment and credits strong performers. Results for the first half of 2014 are up substantially over the same period in 2013, with revenues up 13.5% and operating income up 23.3%. The company’s backlog is $70.4 million compared to $55.1 million one year ago, strongly suggesting continued improvement in trailing twelve months’ results.

Despite the run-up, Paul Mueller Company remains very reasonably priced. Including the reported pension deficit in the company’s enterprise value shows an EV/EBITDA figure of 5.0 and EV/EBIT of 7.0.

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These ratios are likely to fall if the company’s higher backlog results in increased earnings and as the company continues to apply its free cash flow to reducing debt.

Paul Mueller’s large pension deficit remains a risk, particularly now that equity securities comprise over 60% of pension assets. A weak stock market could undo much of the progress the company has made in reducing the size of its pension deficit. However, the vastly increased earnings and cash flow combined with significantly reduced debt make the pension much less of a concern than it was a year and a half ago. Paul Mueller Company’s ongoing debt reduction and improving earnings have shifted the risk-reward balance very favorably since I originally wrote about the company, and I no longer see compelling reasons to avoid the shares.

Alluvial Capital Management, LLC holds shares of Paul Mueller Company for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.