Zicom Group and Orion Marine

A few weeks ago two companies crossed my desk that happen operate in similar segments thus taking a hint (from what obviously is a) divine signal I decided to look into them a bit more.

Zicom Group

The company is an industrial conglomerate (headquartered in Singapore), founded in 1978 and listed in Australia. Core segments (currently) are (i) offshore marine, oil and gas machinery (ii) construction equipment (iii) precision engineering and (iv) industrial and mobile hydraulics (if this doesn’t get you excited I don’t know what will). To note the businesses will be housed in two segments, likely by the next half, into (i) and (iii), which will also house new technology / engineering investments (more below). Zicom is 36% owned by Giok Lak Sim (chairman and group managing director) whose two children are also directors in the business.  To get this out of the way upfront the company is a microcap c. US$46m market cap and US$40m EV and in a good month about a US$1m worth of shares trade.

There are a couple of reasons why this could be an interesting situation.

Committed management. While Zicom is a controlled company, the CEO is remarkably forthcoming in his annual letters and other communication (most recent example here). He has been buying shares since 2008 in the open market and has also acquired shares instead of his cash bonus. In addition, his salary has been frozen since 2007. I could go on for a while but I find it positively surprising in the context of most Asian, controlled companies.

New business. Since 2010 the company has invested in what it calls disruptive technologies in the field of electronics and medical technology (VC type investments generally related to its precision engineering portfolio). The company invested over S$15m ($12m) equity in four businesses (Orion Systems Integration, Biobot Surgical, Curiox Biosystems and iPtec). While such investments can go either way the company is saying that most of these are on the cusp of commercialisation which you can essentially view as a free call option (i.e. not reflected in the valuation). As noted above the business will collapse into two segments, which will help reflect the performance of these new investments.

Valuation. The company is relatively cheap on a statistical basis and trades at 0.6x book (vs 0.8x historical), 5x EBITDA (vs 3-4x historical), 5x free cash flow (vs 9x historical) and 14x PE (vs 7x historical). The shares yield around 4% and the dividend is paid out of conduit foreign income, which is not subject to Australian withholding tax. In addition, the balance sheet is strong with S$22m cash and gross debt of S$15m.

Now what can go wrong. The core segment is offshore marine, oil and gas machinery (it makes winches for rigs and supply vessels) and while sales and orderbook have picked up since last year this is quite cyclical (with normally a 1-2 year lag), however management is positive on the outlook. But this should be considered: while offshore exploration picked up since the financial crisis so did Zicom's sales and orderbook (though remains cyclical) but given where oil price is currently and possibly where it is headed 2015 E&P capex is at risk as well as Zicom's business, which is perhaps not yet discounted (though you could argue that at 0.6x book it is). Base case thesis on the stock seems to be a late, cylical upturn in their O&G segment, however I’d be cautious.

In addition to the above the following could be negative as well: (i) VC investments flop (ii) bad corporate governance (so far no evidence) (iii) continued weakness in construction segment (has been weak as of late), which has exposure to the Australian market and (iv) technicality if you are running a large fund but the stock is quite illiquid.

Apart from a spike in 2011 the share price hasn’t moved materially over the last five years. Profit warnings have also preceded their last three earnings release so I’d say the market was quite pessimistic about the stock. This has been recognised by mgmt and as noted in the chairman’s letter they intend to do something about it so there appears to be a catalyst (let’s see their approach).

Depending on your stomach for volatility on the oil and gas front I think this is a very interesting business, with good and aligned management in place and potential upside from their new investments.

Orion Marine

Orion is a slightly different animal. It is approx. $300m market cap, civil marine construction company that is listed in the US and operates mostly in North America and the Caribbean. The company was founded in 1994 as a construction project management business and expanded into its current shape organically and via acquisitions (most recently a $9m purchase of an Alaskan company).

Orion provides marine construction services (to marine transportation facilities, pipelines, bridges etc), dredging (essentially maintaining waterways/shorelines by removing or adding soil) and other specialty services (demolition, surveying, underwater inspection etc).

In 2013 the company generated sales of $355m (mostly by bidding for various contracts) of which 60% was from the private sector and 40% from various government entities (federal, state and local). Key markets/customers are: ports, marine infrastructure, oil and gas, defence/homeland security etc. As it’s a contracting company backlog is key, which as of end 2013 was $247m ($242m as of Q3’14).

As you’d have guessed it by now Orion’s performance is tied to the general economic cycle but with a lag (just like Zicom so the business is very cyclical). For instance, in 2009 revenues reached $293m with gross and EBITDA margins of 21% and 17% respectively. By 2011/12 the margins were down to 4%/1% and 5%/3%. 2013 seems to have marked a turning point as margins have improved to 9%/6% and on TTM basis 10%/8%. Historically, average margins are 14%/11% (gross and EBITDA, respectively) so the company is trending towards those levels. Key drivers for the decline was drop in demand and also pricing pressure on contracts. So as you can see the business is choppy.

I’ve been looking at this stock many ways but the key story seems to be the recovery in marine infrastructure construction in the US. Just to highlight a few potential avenues for capex growth in this segment: (i) private sector: energy sector growing, expanding and refurbishing waterside infrastructure (e.g. gas related projects – ammonia, LNG, chemicals etc) not just in ports but inland waterways as well (ii) local port authorities growing capex (port deepening etc) for increased cargo volume and larger vessels primarily due to the Panama canal expansion and (iii) government funded programmes to improve, maintain and restore the coast (think damages of recent hurricanes or that accident in the GoM in 2010).

I’d say barriers to entry are medium. You need specialised equipment and trained people (nothing one cannot replicate given the resources) but gaining access to government funded projects (especially on the defense side) require all sorts of clearing thus these relationships are very valuable. On the other hand given that around 40% of revenues are from the government when funding hits a dry spell it can get pretty painful.

Due to the cyclicality it’s hard to value this stock and figure out what are the recurring numbers but an EV/Sales approach could give an indication of what the market implies. If you look since 2008 the peak has been 1.4x (2009; it’s actually been higher but only for short periods so 1.3x-1.4x more reasonable), which dropped to 0.4x (2012; again 0.4x only for short periods and 0.5x is probably a better indicator). It’s currently trading around 0.7x. So those are the ranges.

In 2013 the company generated $355m in sales and this year they are on track to do $385m (mgmt noted Q4 should be on par with Q3). Using 2014 sales and most recent net debt as a base at 1.3x it’s an $18/share stock and at 0.5x it’s worth around $7. Given where we are in the cycle I think 1x eventually is not ridiculous (i.e. lights at the end of the tunnel but not fully out yet), which would imply around $14 (vs current $11).

Commodity prices drive oil and gas capex and while Orion remains bullish on the outlook of private sector projects in the near term I’d tread carefully here (at least in the very near term). As a result of the cyclicality using say the average revenue since 2008 is perhaps more defensive. The same multiples on those numbers imply a range of $6 to $15, and $12 using a 1x multiple (i.e. fully valued) though it could get interesting in the $8-9 range. I think on the long-term horizon this is a very interesting story to watch.

To note Arnold van den Berg, the founder of Century Management, whom I admire greatly, is a large shareholder in the company (around 9% stake) and his thesis is very similar (i.e. marine infrastructure boom in the US of which Orion would be a beneficiary). In a recent interview with Graham and Doddsville he noted that he’d be a buyer should the stock dip to around the $9 levels.

A brief note on Coca Cola Amatil

As I was reading about Orora I came across another Australian listed company. It’s called Coca Cola Amatil and as the name would indicate it is a Coke bottler operating in Australia, NZ and Fiji and slowly expanding in the Indonesian region. It owns SPC Ardmona (packaged food company sold by the current CEO of Orora) and CCA is making moves in developing its alcoholic distribution business as well. Current market cap around $7bn, EV of $8.7bn and trades around 10.4x EV/EBIT and 8x EV/EBITDA. In terms of relative valuation, CCA is cheapest listed Coke bottler around the world; on a forward basis it is trading around 8.5x EV/EBITDA (vs 11x peer average, based on consensus).

What caught my attention was that the stock has been hitting 52-week lows. If you look over the last 6-9 months CCA has been on a downward trend from around $13 to $11 to April 2014 when a company released a trading update, which sent the share price down to the $9 levels, essentially wiping out c. $3bn market cap in the meantime.

It all started in February when CCA released 2013 annual results:

• It showed a writedown of around $400m (mostly non-cash) related to SPC Ardmona as the business came under pressure from high AUD and product dumping from foreign competitors
• The Australian non-alcoholic beverage unit, which is the bread and butter, was hurt by competitor price cutting, requiring more promotional spend and a generally weaker consumer environment
• The Indonesian unit was impacted by price cuts from lower cost competitors, wage and fuel price inflation as well as currency moves
• Then came the April trading update, which essentially said that EBIT is expected to be weaker 15% yoy in H1’14
• CCA also announced a strategic review under the new CEO, which initially resulted in the reorg. of the Australian unit (announced in May)

I could go on but I think the picture is clear. CCA is coming under serious near-term difficulties both home and abroad, which are partly external (pricing pressure from competitors, currency etc) and partly internal (most important are the bloated SKUs and the high cost base).

The chart below is worth spending some time on. This essentially shows the Australian non-alcoholic beverage business’ SKUs and the volume sold by SKU. Complexity in the distribution channel increased substantially and as SKUs rose marketing spend was diluted, taking away from the core products.

Source: CCA filings and factbooks

Furthermore, the substantial increase in SKUs didn’t translate into relatively more volumes; between 2005 and 2012 volumes in this segment rose form 322m (unit case) to 349m, which is an 8% increase (to 2013 it’s only a 5% increase). The recently announced review will focus on a much-awaited SKU rationalisation, which should also translate into cost reduction and elevated focus across the brand portfolio. CCA also noted that they plan on closer cooperation with Coke (which owns 29% of CCA).

CCA is getting cheaper but is far from being very attractive in my mind. I generally like to refrain from timing an entry (it’s virtually impossible I think), but the changes required - reducing SKUs and shifting CCA into a lower cost base - will be a lengthy process for sure and there are still questions on SPC Ardmona, Indonesian business and so on. There will surely be more pain in the near term with the reorganisation especially in an environment where raw price increases are not able to be passed on, but the new CEO’s outline seems to address to key points head on. Let’s see, perhaps there will be further entry opportunities.

Orora, a spin-off from Down Under

Orora is an Australian listed packaging business that presents an interesting spin-off opportunity. It used to be part of a large Australian packaging company named Amcor, however in order to focus the business it decided to split the business into two (1) remaining of Amcor to focus on specialty packaging (healthcare, personal care, F&B etc) and (2) Orora on fibre, beverage packaging in Australasia and packaging distribution in North America. All figures below in A$.

While admittedly packaging isn’t the most exciting business in the world (no offence meant to anyone), Orora could be a textbook spin-off case. Amcor is a much larger company with market cap of $13bn while Orora with $1.7bn, currently. Thus when investors received shares in Orora (1:1 distribution) Orora’s share price didn’t exactly tank but definitely saw sharp selling. Now the share price is up around 20% since the low point to $1.4 where it has been flat for the better part of last three months. Orora has a couple of things going for it, namely an on-going restructuring and capable management team.

As a quick detour, in the last three years Orora generated revenues of $2.9bn on average and EBIT of $150m across its two segments. The bear share of this is from the Australasia business, which produces corrugated packaging (think cartons, boxes, recycled paper and so on) and packaging for beverages (cans, glass bottles etc). In each of these segments it has significant scale and either no. 1 or 2 in the AUS/NZ markets, which is key in capex intensive, low-ish margin businesses. The second segment is Packaging and Distribution based in the US and engaged in distributing packaging materials and shipping/logistics services to clients, operating under the Landsberg and MPP/CK brands.

Now back to the story around Orora. Prior to the spin-off Amcor was busy restructuring the business and moving away from lower margin businesses, resulting in closures/divestment and reorganisation of Orora’s manufacturing facilities and operations in its home turf along with bolt-on acquisitions to gain scale and improve margins. Management noted that they are continuing to reorganise the business and identified around $95m cost cutting opportunities over the next few years. In fact, $12m has been achieved in 2013 and $16m in H1’14 (of $30-40m budgeted) with about $20m related capex to be spent over 2014/15. Now it’s unlikely that all of the c. $95m goes to profitability, as they’ll probably share some of the upside with customers, offset cost inflation etc. In any case, this programme will lead to meaningful increase to profitability.

Orora isn’t exactly what you’d call a high-growth business; in fact it’s a mature and defensive. Prior to the spin-off, management initiated a fairly aggressive dividend policy with a 60-70% payout ratio. Delivering on the restructuring is key if one were to see meaningful increase in dividends and value. In H1’14 ORA earned $52m after tax and management declared $0.03 per share dividend (around $36m or 70% payout) or 4.3% annualised yield based on current price.

Orora is left with $65m of benefits to be achieved over 2 years or so (considering that what has been achieved YTD H1’14 is probably priced in). Assuming that only 80-90% of this stays with them (some goes to share with customers, cost increase etc) we have about $35-40m post-tax net benefit, which assuming a 65% payout could add around $2c to the dividend. Assuming a 4% yield (based on current but further compressed) this could add $0.5-0.6 to the share price taking it closer to $2 for a c. 35-40% upside from current. Now of course this is over 2 years or so. The above assumes steady state i.e. no growth in the businesses and a defensive view on the restructuring. Additionally, as capex subsides management could use excess cash to buy back stock or pay down debt (which for now is fairly high at around 3x EBITDA on a net basis).

What makes me a bit more comfortable about this restructuring is Orora’s management. Prior to joining Amcor in 2009, the CEO spent 8 years at SPC Ardmona (packaged food business in Australia). He reorganised and grew the business via M&A and eventually sold it to Coca Cola Amatil (Australian beverage co) in 2005 after three-way deal talks. In addition, him and the chairman have been buying shares in the open market recently, which can be seen as a positive step.

To sum, Orora presents a possibly rewarding spin-off opportunity in a defensive business with the on-going restructuring serving as a catalyst executed by a capable management team, who have skin in the game.