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CMI

CMI – value in the coal stack

I’ll start by saying CMI is really really cheap. It is so cheap that it has fallen into the realm of the elusive “net-net” (current assets – total liabilities > market capitalisation).

CMI was listed in 1993 and has had a colourful corporate history (which I won’t get into). Much of that chequered history has passed and today CMI operates a simple business which manufactures and supplies electrical products; electrical couplers (Minto) for the underground coal mining industry and electric cables to the infrastructure and construction sectors under the XLPE, Aflex and Hartland brands.

Supplying speciality electrical cables is highly competitive with CMI having no real competitive advantage. Nonetheless, there is some brand awareness given this division has been around since 1998. Although this business is low margin, it makes up the bulk of revenue. Speaking to management, it appears that this business currently makes up circa 75% of sales and 50% of gross profit.

Minto is CMI’s cash cow. It manufacturers and supplies electric couplers to the underground coal mining industry and has around 60% – 70% market share (based on this broker report). The merits of this product are well articulated in this post on CMI. A summary of the strengths of Minto are as follows:

  • Underground coal mines are highly flammable environments and strict government regulations (Australian Standard: Electrical equipment for coal mines – 2290.1) provides some competitive advantage against foreign imports. Eaton Corporation (US company) also supply electric couplers under its Cooper brand.
  • The product has an overhaul life cycle of 4 years and given the hazardous environment and brand awareness, it is very rare that clients switch brands.
  • From a cost perspective, it is relatively cheap for miners to purchase (price range from $600 – $3,000) and therefore less price sensitive.

Financial information

Below is a summary of the electrical division’s financial information. The electrical division’s NPAT was unavailable prior to 2015 as there were other businesses which were consolidated but has now been disposed.

cmi-pl

Revenue rose from 2010 to 2012 but has been steadily falling over the last 5 years which have tracked the coal price movement over the same period. Thermal coal prices tanked during the GFC, falling to a low of US$65 in March 2009 and then ran up to a peak of US$142 per ton in January 2011. It then started its long decline and by June 2016 it was US$57 per ton.  As prices fell, coal miners cut capital expenditure and shelved expansion plans which dampened demand for Minto’s products.  The slump in the resource sector also resulted in increased competition for the cable business as reduced work in the resource sector lead to more suppliers tendering for infrastructure and construction projects.

A summary of its financial position as at June 2016 is as follows:

cmi-bs

CMI has no debt and cash of $26.7 million. The cash was largely accumulated from the sale of the TJM division. Based on 34.8 million ordinary shares, its net asset position is $1.44 and the current asset less total liabilities per share is $1.17 compared to the current share price of $1.05 making it one of Graham’s net net which are rare nowdays.

­Valuation

I have analysed the market’s implicit value of CMI’s operations based on the current market capitalisation.

cmi-mkt-val

Netting off the cash balance from the current market capitalisation implies that the market is currently valuing the operating business at a PE ratio of 2.9x.

I think the market is far too pessimistic; assuming 100% of net profits is paid out an investor investing at these levels only needs 3 years to get a payback on his/ her investment. Therefore, to exceed market expectations at current prices, CMI does not need to find new customers, all its needs is for its existing customers to stick to the overhaul life cycle and replace them with new Minto couplers.

At current coal prices many local thermal coal miners are making a loss and new coal mines are unlikely to be commissioned. Longer term, coal as a source of energy globally is set to decline due to climate change which has negatively affected sentiment. However, I believe that Australian coal production will set to continue for many decades as:

  • Even though coal prices have halved since 2012, underground coal mine production has increased over the past 5 years as coal miners have managed to slash production cost.

coal-price-and-prodn

Source: Department of Industry, Innovation and Science – Office of the Chief Economist
  • Production is likely to be maintained in the short term regardless of coal price movements given many coal miners have signed take or pay contract with rail and port providers.
  • The US, China and Indonesia have all experienced declines in coal output. These declines are driven by government policy and declining coal prices. Large coal miners such as Peabody Energy have filed for bankruptcy under Chapter 11. The fall in global production will help to support coal prices and the recent uptick in coal prices (August – US$72 per ton) maybe a sign that the bottom has passed.
  • Although there has been some decoupling of the Australian dollar to commodity prices, by and large the Australian dollar is still seen as a “commodity currency”. This has benefited coal miners as the fall in US dollar coal prices was cushioned by a corresponding fall in the Australian dollar. The Australian dollar is unlikely to be completely decoupled from commodity prices given resources are significant Australian exports which is an advantage to Australian miners.
  • Even with the huge push into renewable energy, coal will still be a significant source of power globally for the next 20 to 30 years. In the last couple of years China has built many coal power plants which will continue operating for decades. Coal is still a cheap reliable form of power and is appealing to many developing countries in Asia. Even Germany has recently increased coal power capacity as a result of the inability of renewal energy to provide constant power supply and closure of its nuclear power stations.
  • Coking coal production is still profitable at current prices and steel demand is expected to continue rising as more developing countries built infrastructure and move its citizens from the countryside to cities.

Potential catalyst

CMI’s current size makes it less than ideal to be a listed company due to the additional cost imposed. I’ve calculated that CMI could potentially save $500k, approximately 10% of its pre-tax profits if it was privatised. The bulk of these savings would come from reduced audit and tax fees, elimination of the share registry fees and savings from staff cost and share based payments.

Leanne Catelan controls nearly 40% of CMI. Hypothetically speaking, I’ve calculated that she could potentially earn a 16% yield by acquiring the company at net asset value ($1.44 per share), extract the cash ($0.77 per share) and enjoy increased net profits from the above savings. Obviously if she were to do this now, she would probably only need to pay a 25% premium to the current share price to get the deal done which works out to be around $1.30 and earn herself a 20% yield.

Risks

I see the key risk with CMI is with the use of its cash balance. Management has stated that it wants to use the cash for bolt on acquisitions and acquisitions have inherent risks from pricing to cultural assimilation.

Another risk is talent related, Jeff Heslington the competent general manager of the electrical division who has been with the company for 17 years has given his notice to resign. Finding a competent replacement will be crucial.

Conclusion

I believe this is a deep value stock as market expectations are very low. Although coal prices have been in a slump for the past 5 years, Australian underground coal mine production has not gone backwards which is a good sign for Minto’s future demand. I think it is likely that a bottom in coal prices have been reached and there are some signs (acquisition of the Bengalla coal mine at a decent value, 26% rise in thermal coal price from June to August 2016 and doubling of Whitehaven’s share price in the last 2 months) that the sector will start to recover.

10 replies on “CMI – value in the coal stack”

Hi There thanks for that I agree with everything you wrote. I last had a position when the fight was going on but sold at a small profit as I was disillusioned by both sides. The real problem for me was the TJM business and getting it right. Personally I never thought they would find a buyer for it if they did not get it right. I was wrong and lost track of it until I ventured into CAA ( Capral) on HC and found my old friend – GPASAS and then looked at his posts. CMI popped up again.

I have done the same numbers and even in this bottom of the cycle I get to a valuation that exceeds the 1.44 the low side is $1.48 and the upside for me is $1.78.

The risks are exactly as you outline – You have no control of the investment of the cash. I had a small position in HIL ( Hills) and that was a disaster and I sold out after speaking to some who worked at one of the companies they took over.

However their first event was to return capital to shareholders – that made me feel a bit more secure.

The bigger issue that you seem to ignore is the management:

I am concerned by Heslington and his notice. I dont think this business needs a $400K CFO so happy that that seems to infer it is in notice period.

My only comfort is that after talking to a few friends in the electrical supply business (albeit smaller players) they say there are quite a few executives out there that you could attract. That has made me a lot happier. So I dipped my toe into the water.

I have a few contacts around another unlisted control business and want to explore if there is any synergy…

The franking credits mean the company can realistically pay out the entire free cash flow of around 70c. You would still be able to pay a 6c fully franked dividend from the existing business and as you say it could be taken off the market. I am not looking for that would love to own a share paying 6c plus franking for a net cost of say 30c…

Yes, I did note the risk of Jeff resigning and that it was crucial to find a competent replacement. I’ve heard that Jeff was a good operator and I think a good GM is probably more important to the cables side of the business. Minto is a market leader with a strong brand recognition so as long as the new GM doesn’t rock the boat too much, things should tick along nicely. Anyway, I heard that Jeff may not completely leave the business.

Hypothetically speaking, Leanne could put forward a takeover offer of $1.30 (which values the company at $45.3 million) and it would cost her $27.2 million for the 60% that she doesn’t own. Since CMI has $27 million in cash, she could use the cash to pay for the remaining shares and get 100% ownership of the operating business for no out-of-pocket cost.

Since the ATO ruled that the previous capital return of $10.5 million wasn’t taxed as a dividend, I assume that the remaining cash (which was mostly from the sale of TJM) would also not be taxed as a dividend or like you say, even if it was deemed a dividend, the franking credits should cover the cash balance.

I believe Heslington will not be sticking around, there are also rumours he has had several approaches.
This business tends to lose the right people

Thanks for your query Bernard. I will attend the AGM this Wednesday to find out a bit more before commenting.

Hi there , I am trying to get a handle on the new guy – James (Jim) Johnson – would be good if you can get any info on him. There is one on LinkedIn and SME360 – operates from Adelaide but he seems to be too good for a company this size. If it is him he has a very good reputation here…

Also I think its interesting to understand why the share buyback?

Those are my burning issues…

I spoke to the company secretary and she said that the new guy has 20 years of experience in the electrical sector working with a multinational (I can’t remember the name).

My take on the buyback is that the major shareholder is trying increase control.

Hi there

I only skimmed through the material, but,

What about the $7 million in franking credits?

If you look at the annual report under notes, they have the potential to pay fully franked dividends of $22 -23 million. That means @ 30% $7 million in credits.

The valuation is potentially $1.70

Thanks for the comment. Yes, the franking credits are potentially worth alot if management decides to payout the surplus cash as a dividend.

Re : increasing control

Of course!

No one is interested in the company, and she is slowly using multiple methods to increase her holdings.

– 3% per 6 months under creep rules
-capital returns to fund her purchases
– buybacks to reduce outstanding shares

Good on her. We would all do the same if we were in her position. (We just have a different priority and have to hold out for a better deal)

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