Emeco has reported a modest result for the first quarter of FY16 but this result remains some way from alleviating concerns about its credit profile. The company’s cash balance has fallen to $20.9m at 30 September 2015 following the September bond coupon payment and concerns over the company’s liquidity remain
Emeco has reported a modest improvement in its first quarter (1Q16) result versus 12 months prior (1Q15) however we note 1Q15 was a very weak result for the company. Emeco’s quarterly performance can be subject to seasonal fluctuation so a single quarter’s performance can be subject to variability.
Key points from 1Q16 result
- Revenue was up 12% from 1Q15 to $55.2m, however when compared with the prior quarter (4Q15) revenue was down 15.5%. Again we emphasise quarterly results are subject to seasonal fluctuation
- On the back of the ‘Project Fit’ cost initiative program, Emeco also noted that the group’s EBITDA margin improved 15% to 24% from 1Q15. As a further comparison, the FY15 EBITDA margin was 17.9% and the FY14 EBITDA margin 27.9%
- $9.1m in positive operating cashflow was generated during the quarter (before bond coupon payments) but after allowing for the $15.4m semi-annual coupon payment the company was free cash flow negative over the quarter. The company is expecting however to be free cash flow positive over the remainder of 1H16 but no figure or guidance has been provided
- The NSW, Queensland and Chile businesses are currently performing reasonably at relatively high utilisation levels, however operating difficulties in WA and Canada are offsetting the higher performing regions and the overall business is not turning around sufficiently to address the high credit risk
Liquidity pressure looms
Cash flow generation and liquidity are critical issues for Emeco. Following the September bond coupon payment of $15.4m, Emeco’s cash balance fell by $6.9m during the quarter to be $20.9m at 30 September 2015. On this cash balance alone, the company will only be able to fund one further semi-annual bond coupon payment.
In terms of other available liquidity, the company has a $75m asset backed loan which remains undrawn and of which 50% ($37.5m) can be drawn without being subject to financial covenants. However, while the asset backed loan is a source of liquidity, it will also erode bondholders’ security position to the extent that it is drawn.
If the company is unable to fund its bond coupon payments, then Emeco will be in default and bondholders will be able to exercise their rights in a default scenario, including the enforcement of security. On the analysis above the company can fund the next semi-annual coupon payment out of cash and a further two payments by drawing on 50% of the asset backed loan.
Therefore, the next 6 to 12 months of operating performance will be critical to the company’s future. The company is guiding positive free cash flow over the remainder of 1H16 however no guidance has been given to the amount of cash flow. The first quarter operational performance has been positive but the company needs to generate positive free cash flow over and above bond coupon payments.
Potential scenarios
Emeco’s senior secured bond is rated Caa1 by Moody’s with a negative outlook (equivalent to a CCC+ rating by S&P) and B- by S&P with a negative outlook. S&P currently assigns a recovery rating '3' on the bond, reflecting its expectation of "meaningful" recovery prospects (50%-70%) in the event of default.
We reiterate that Emeco is currently at a high risk of default given the low commodity price environment amongst other factors. Based on recent historical S&P default tables, credits within the ‘CCC/C’ range have experienced a 43.77% probability of default while ‘B-‘ rated credts have experienced a 23.2% probability of default over a four year period.
The Emeco bond is currently priced at a ‘distressed’ level, in the mid-$50 range. In the absence of some form of corporate action with the company (eg: a takeover) it is unlikely that full principal will be repaid at the bond maturity date in 2019. We note above S&P’s expectation of 50%-70% recovery prospects in a default scenario.
While there are a multitude of possible future outcomes, at this stage we highlight three potential scenarios:
- Default before maturity: The company runs out of liquidity within the next 6-18 months and defaults on its coupon payments. The company enters into administration, bondholders enforce their security and recover whatever proceeds are made available from the sale of its equipment assets. If the company cannot improve its financial performance such that it is generating consistent positive free cash flows then the downside case will become the more likely scenario
- Default/haircut at bond maturity: the company is able to pay its coupons up to the maturity date of the bond with modestly improved performance, however the full principal outstanding of the bond cannot be refinanced/paid out and bondholders accept a ‘haircut’ as part of the refinancing solution or an event of default occurs if the company cannot raise new debt
- Some form of corporate action (eg: takeover, merger) which either improves Emeco’s credit profile and/or triggers a change in control redemption. While we consider this scenario unlikely, we have seen recently with the likes of Coffey that corporate activity cannot be ruled out as a scenario, particularly when the share price of a company is heavily discounted to historical levels
View the company’s ASX announcement.