Following Emeco’s 1H16 result, we assess the liquidity position of the company and options for bondholders
Emeco has released its 1H16 results (link to ASX announcement here
). Positive results include: the improvement in the EBITDA margin due to cost reductions and strong performances in certain regions. However, revenue has not grown, free cashflow remains negative, the Canadian oil sands business has deteriorated and the company remains excessively leveraged.
Key points:
- EBITDA is up AUD7m to AUD23.2m on 1H15, but down AUD4m on 2H15. The company has guided FY16 operating EBITDA of between AUD53m-57m which would imply a very high FY16 net debt / EBITDA ratio of 6.8x
- New South Wales is performing well and the Queensland business has turned around well. Western Australia utilisation is down reflecting the weakness in iron ore. Chile also recorded a solid result (strong EBITDA margin of 41%) and Chile fleet utilisation is a high 94%
- The Canadian oil sands business has experienced significant weakness due to the sustained low oil price. Weakening market conditions have resulted in operating utilisation down to just 14%. The business needs to be restructured and the Canadian fleet would need to be relocated or sold. The company wrote down the value of the Canadian assets by AUD97.4m in the half year as a result
- We note the company is expecting an improvement in cashflow generation in 2H16, through improved volumes, lower operating costs and capital expenditure. Executing a cost cutting project will achieve AUD26.7m in savings over FY16
- The company is in the early stages of introducing a new technology, EOS Mining, which aims to introduce productivity benefits to mining clients. Signs with its first client (Alkane Resources) are promising but the technology is still in an early stage
Noting the result, we would like to focus on the ‘where to from here’ question which many holders are asking. At this stage we are not seeing enough of an improvement in Emeco’s operating business and cash is deteriorating. We lay out the potential options for existing Emeco bondholders:
- Hold onto the investment and continue to receive a relatively high coupon as long as the company remains solvent. The high coupon provides a level of recoupment of capital, but ultimately we do not expect bondholders to receive a full return of principal on the bond. A ‘hold to maturity’ strategy would be premised on an expectation that the company can improve its cashflow profile and reduce leverage, and would clearly be the most positive result for bondholders. The company still has around AUD50m liquidity through AUD24.4m of cash and AUD75m of an asset backed loan (which can be drawn up to 50% without maintenance covenants) but as we outline below, the cash balance is being eroded
- Sell the investment and realise a (potentially material) capital loss. The capital price of the bond has fallen significantly and is pricing at a ‘distressed’ level (USD40s-50s) reflecting a high probability of default and haircut on bond principal. We note the bond does not actively trade, and any institutional bid is likely to be coming from a hedge fund with an extremely positive view on a resources recovery, or a distressed debt fund which is willing to restructure the business and extract an alternative method of return (say, for example, through a debt for equity swap)
On the first option above (continuing to own the bond), the ability of the company to continue to pay coupons will ultimately come down to a) free cashflow generation and b) liquidity. On free cashflow generation, Emeco has remained a capex intensive business despite the significant falls in its earnings and we haven’t seen a cut to capex as we have with other mining companies. This has meant free cashflow generation has persisted negatively in recent periods. As a result the company’s cash position has fallen from AUD34.1m at 31 December 2014 to AUD24.4m at 31 December 2015.
Asset disposals are down from AUD15.1m in 1H15 to AUD6.2m in 1H16. The company has stated that the deteriorating second hand equipment market is decreasing the ability for the business to generate value from disposals. Thus the value of asset disposals as a source of cashflow is deteriorating, and as such free cashflow could decline further without an increase in operating earnings.
In the absence of a material improvement in operating (and free) cashflows, it is difficult to see the company’s cash balance improving over time. As stated in our earlier article on Emeco, if cash continues to burn at a rate of AUD10m per annum the company probably has another 2-2.5 years of cash balance available (or 4-5 bond coupon payments worth USD20-25). However, on top of the cash balance we note that the company also has an AUD75m asset backed loan (ABL) which has no maintenance covenants when drawn up to 50% of the loan, providing another AUD37.5m of liquidity. The company has not yet drawn on the facility but had utilised AUD11.1m of bank guarantees against it, implying that there is another AUD26.4m of liquidity under the ABL over and above its cash position. We understand the ABL is backed by a pool of assets and would rank ahead of the bond in a default scenario.
So, unless the company is required to provide further bank guarantees, we estimate overall liquidity available to the company at around AUD50m, which we think would be enough to get the company to bond maturity on an AUD10m pa cash burn rate. Between now and the maturity date, Emeco is due to pay seven more semi-annual coupons worth USD4.9375 or USD34.5625 per USD100 of bond face value in total aggregate coupons.
If earnings were to deteriorate further from current levels, we expect the company would seek to start a debt restructuring process before it completely ran out of cash, which may involve bondholders swapping debt principal for equity in the company, or some other compromise. Given the low value likely to be achieved under a forced liquidation scenario, we believe a debt restructuring would be a more likely and a sensible ‘default’ scenario rather than an administration and liquidation scenario. Values of secondary market mining equipment have fallen materially and bear no resemblance to the accounting value of the asset of the balance sheet which adopts a ‘value is use’ methodology. If performance shows further signs of deterioration, then a restructuring could be required before the maturity date of the bond. One example of a ‘quasi default’ is a debt for equity swap we outlined in our previous article on Emeco.
If the company remains solvent until the 2019 maturity date, we don’t expect that bond principal will be fully refinanced, and bondholders are likely to face a haircut on their bond principal (which would count as a default). Given the high coupons on the bond, a scenario where bondholders hold to maturity and receive some form of a return on principal (say 50c in the dollar) would be a positive outcome in the context of the company’s current financial situation and probably a better result than selling now at a heavily discounted price.
Ultimately, the decision on whether to sell or hold also comes down to investor preference. Obtaining a certain (but heavily discounted) cash price now, or continuing to hold onto the investment in the hope that earnings will turn around between now and the maturity date. The company has advised that it is continuing to cut costs and that cashflow generation is expected to improve in the second half of year. The company has bought back USD52.3m of bonds and is likely to keep doing so if the capital price remains heavily discounted and an opportunity emerges.
Maybe it’s worth holding on. The Emeco 9.875% US dollar bond maturing in 2019 is currently offered at an indicative capital price of $47.25.
Please contact your FIIG representative for further information and current pricing levels on the Emeco bond. Available to wholesale investors only.