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CMI

Entering muddy waters – CMI

I apologies for this post being somewhat late. As I have anticipated, the resolutions to turn CMI into a listed investment company went through which means that Glennon Capital (GC) is currently responsible for CMI’s cash hoard of over $20 million or $0.57 per share which is more than half the current share price.

What was relatively a safe asset (cash) is now at risk. The value of the cash is now in the hands of GC. Although future investment outcomes are nearly impossible to predict, we can form some views on the manager based on another LIC that they manage, GC1. In assessing a manager, I put them through 3 important tests:

  1. Whose interest is being put first (managers or shareholders)
  2. Approach to risk and investment philosophy
  3. Track record

The first one is a no brainer, if the manager is putting his or her interest ahead of the shareholders then good luck to the shareholders.  Secondly, I prefer a manager who puts risk management first ahead of investment returns. I don’t like a manager who aims for the highest returns. Howard Marks gives a good example of his client who over a 14 year period consistently had returns between the 27th and 47th percentile of all managers at the end of the period ended up with returns at the 4th percentile of all managers. It’s no use having the top investment returns 1 year and then blowing up the next and if you take risk and shoot for the stars, you’re likely to blow up big.

I’ve attempted to put GC to the above test based on their history, which is only over two years and in terms of track records is rather short. To illustrate some points, I have inversed the test from least important to most important.

Track record
GC1’s investment track record is only for 1.5 years years so I also had reference to a 5 year track record another fund managed by GC (Glennon Capital Small Companies Portfolio) which was illustrated in GC1’s prospectus.

As you can see, the above after fees performance of Glennon Capital Small Companies Portfolio has outperformed its benchmark (ASX Small Ordinaries Index) over 5 years by 11.4% (annualised basis). The chart below illustrates the investment performance of GC1. According to it’s February 17 investment report, since inception the fund return (before fees) is 22.33%. The after fees annualised returns were not disclosed.

Based on the above returns, GC’s investment record appears to be quite satisfactory.

Approach to risk and investment philosophy
Based on GC1’s propectus, GC’s investment philosophy is to invest in companies outside of the ASX S&P 100 who have:

  1. Superior management and sustainable business that operate in industries with barriers to entry and growth prospects;
  2. Undervalued
  3. Do not use leverage
  4. Long term focus

A review of GC1’s portfolio as at June 2016 shows that the portfolio is made up of 41 stocks with their individual weights ranging from 8.05% (maximum) to 0.02% (minimum) and the average weight being 2.05%.

Since inception till 30 June 2016 (FY2016) and 28 February 2017, GC1’s portfolio returned 15.86% and 22.33% respectively. This compares with it’s benchmark S&P ASX Small Ordinaries Accumulation Index return of 18.89% and 24.36% respectively over the same periods.  GC1’s returns doesn’t appear to vary too much from the index which is not surprising given the number of stocks invested. The advantage of having 40 stocks in a portfolio mean that potential for material underperformance against the index is unlikely but on the same token, the potential for material outperformance is also unlikely.

Whose interest is being put first
Now this is where things get interesting. Based on the FY16 and HY17 financial reports, the fees paid out to GC are as follows:

Since inception, GC has earned $1.1 million in fees.

The chart (click here for better view) below shows both the performance by GC1’s shares since inception against the S&P ASX Small Ordinaries Index Fund ETF. As illustrated, the benchmark far outperformed GC1’s shares.

GC1 is currently trading at 94 cents and has paid a total of 4.75 cents in dividend over its listed lifetime. Therefore, an investor who invested $1 at the IPO is about break-even at today’s share price.

How is this so you may ask? Why didn’t the share price track the 22.3% portfolio returns earned since its inception to February 2017?

There are a few reasons for this.

  1. The fund is trading at a slight discount to its NTA. Based on it’s NTA at the end of February, it is currently trading at a 5% discount.
  2. The reported portfolio returns are gross. Fund manager fees and other fund overheads would have eroded the gross returns.
  3. However, the main culprit is the options that were granted to shareholders during the IPO to entice subscriptions. At IPO, one option was given “free” for every share subscribed.

These IPO options were actually bait on a hook, read this great write-up on LIC options.

These “free” options created a huge overhang over the share price due to the potential dilution they represented. Even if the options are exercised, they reduce the percentage returns for an investor than compared to a situation where the options were never issued.

In GC1’s case, more than 60% of the options were not exercised at the maturity date. What did GC1 do? It went into an underwriting agreement with a broker for the unexercised options. So this meant existing shareholders were not only diluted but probably copped the underwriting fee as well.

At the IPO, GC1 had 21.69 million ordinary shares and as at 31 December 2016 (afterthe options were all exercised) it had 46.95 million shares outstanding. This gives you a sense of the magnitude of the dilution. Nearly all of the portfolio returns have been diluted away.

So who wins from these options? Well, given the typical fund manager fee structure, the winner is always the fund manager as options generate more FUM and more FUM means more management fees.

Conclusion

It is quite tricky to balance out the advantages and disadvantages for CMI at this juncture. On one hand, you have the good points which are that its cheap, has a good electrical business and exposed to what is probably a low point in the coal mining cycle.

On the other hand, you have equity investments which are hard to quantify and a major shareholder whose interest may not be fully aligned with the minority shareholders.

So on balance, taking into consideration all the facts, I will hang on to the shares due to:

  1. Leanne as a major shareholder has both plus and minuses in my opinion. She has the largest interest in CMI and will act against any indiscretions against shareholders interest.
  2. Historically, the cash balance earned next to nothing due to the low interest rate environment and it would not take much to increase this return. If GC adopts a similar portfolio diversification strategy to GC1, then I think over the longer term our cash should generate near market returns. The only issue is timing and equity market risk (systematic risk).

For my original CMI post, click here.

 

 

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CMI

CMI – change of business nature

I was pretty excited last Friday when CMI announced a trading halt. I saw the trading halt notice first and didn’t notice the prospectus until much later in the day. So for a moment there, I had hope that a takeover or a return on capital was on cards but unfortunately it was not to be.

It turns out that CMI wants to morph into an investment holding company and will appoint Glennon Capital to manage the surplus funds. The idea is for the portfolio to have a 100% interest in the electrical division and with stakes in about 10 to 20 small companies (listed and unlisted) which will be selected by Glennon Capital.

Having read the prospectus, I think this idea is silly and I get the impression that it was not thought through well enough by management. My concerns in order of priority are:

  • I invested in CMI to get exposure to Minto and the coal sector. I certainly didn’t invest on the basis that CMI could make profits from punting its capital in the stock market. Therefore, I believe that management should seek to increase shareholder value by prioritising the use of its surplus funds to increasing the competitive advantage of its business, for e.g. spending on marketing activities, research and development or integration/ acquisitions. If there are no other avenues to increase the competitive advantage then it should return the surplus capital to its shareholders, period.
  • Potential conflict of interest. Glennon Capital is also the manager of Glennon Small Companies Ltd, ASX code GC1 (a listed investment company) with Michael Glennon, the chairman having 4.5% interest in GC1. In the event that a stake in a great investment is available for purchase, I wonder how Glennon Capital will divide the available investment opportunity between GC1 and the new CMI fund? Or if a similar investment in both funds goes bad, which fund will be able to sell first? Or worst still, what if GC1 sells its bad investments to the new CMI fund? I’m not implying that Glennon Capital is run by dishonest individuals but I’m concerned that management has not considered these conflicts as there were no safeguards mentioned in the prospectus.
  • If Glennon Capital invested in unlisted securities, how will their performance be measured when the securities are unable to be marked to market? Will a friendly valuer be called in to determine the value?
  • If management believes that Michael Glennon is a great stock picker, why not invest directly in GC1? At least in that fund, Michael Glennon has skin in the game with the performance fee hurdle being fairer (see below).
  • Management and performance fees.  Glennon Capital will charge 1% management fee and 20% performance fees with the performance fee hurdle being cash rate plus 2%. GC1 has comparable remuneration structure with one distinct difference; its performance fee hurdle is based on the S&P ASX Small Ordinaries Accumulation Index. This is a much fairer (and more difficult to achieve) hurdle than the cash rate plus 2%. Compared to GC1, why is CMI making it easier for Glennon Capital to earn their performance fees?

I will be voting against the resolution to change the nature of the business but I think it will be futile exercise given management has 40% of the votes. However, I hope that at the very least some of my concerns above get addressed so that we can get a better overall deal.

Sigh, a dividend would have been such a great way to utilise those franking credits ….

.

 

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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.