CMI Limited CMI AU
December 16, 2008 - 10:41pm EST by
mpk391
2008 2009
Price: 0.55 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 19 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

Despite its size, CMI is interesting since it's so rare to find a fantastic business that has anything to do with mining.  Management is smart and shareholder-friendly.  And yes, it's really cheap:  the EV/FCF multiple is 3.7X on the year ended June 30, 2008.  FY09 will be a tougher year, so perhaps the forward multiple rises to 6 or so.  Plus you get a couple of ancillary businesses which together are at breakeven today, but probably have real value.

My apologies for the erratic liquidity in this name.  On a good day it's 250K shares, on a bad day it's zero.  The biggest buyer in the market is the new Chairman of the Board, who recently bought a third of the equity around $1.20/share and is adding more all the time.

CMI was founded in 1991 by Max Hofmeister as a rather unremarkable Australian auto parts company.   When that industry fell into secular decline, Hofmeister tried to acquire his way out of the problem.  Along the way, he regularly overpaid both himself and his buddies on the Board. 

Unlike the rest of his shopping spree, the electrical component makers he bought have actually worked out quite well.  These are Peaston (1997), Heartland (1998), Minto (1999), Aflex (Oct 2004) and XLPE (July 2006) - collectively, the "Electrical Division."  For the most part, the products are cables and connectors designed for specializedindustrial use under harsh conditions.

Minto - the cash cow
Minto makes couplers for the mining industry.  Modern mines use lots of electricity and have miles of electric cable running all over the place.  Couplers are specialized devices that connect one cable to another, or to the machine that's using the electricity.  This rather prosaic bit of equipment turns out to be a very lucrative niche for a few reasons:
 
  1. Couplers take a lot of abuse, and when one breaks, the true cost to its owner is not so much the money spent on fixing/replacing the coupler as it is the lost productivity of all the miners and equipment who are sitting idle while repairs are under way.  The latter is many times the former.  As a result, mines tend to use only one brand so that they're more likely to have the necessary spare parts on hand, and so that their guys are totally familiar with the equipment.  Some really big mining operations dual-source, but some don't.  Since couplers are only a tiny part of total costs, buyers are not price sensitive.
  2. There's also a safety issue:  the air in a mine often contains potentially explosive gasses like methane - particularly in coal mines (hence the proverbial "canary-in-the-coal mine").  If an electric spark were to ignite this gas, you'd get a big explosion that can kill up to dozens of miners.  Thanks to product improvements and very strict government regulation, Australia has not had a major incident of this sort since the mid-1980s.  The desire to keep it that way makes buyers even less price sensitive - nobody's going to risk people's lives and their own career on some untested brand just to save a little money.
  3. These factors combined lead to yet another positive:  a near total absence of foreign competition.  Because miners want to always have spare parts on hand, the lead times on overseas orders become a real problem for them.  Further, Australian electrical standards are unique and government approval is hard to get.  Hence, Australia just isn't an attractive market to anyone overseas.  For a North American supplier, you'd be looking at re-tooling your production lines and slogging through the approval process just to enter a market that's only one tenth the size of your own.  And you'd still have the issue with long lead times.  The same would apply to anyone in China, even if they overcame buyer concerns about product quality.
  4. Finally, the business isn't capital-intensive.  Capex/depreciation is about 1.5% of sales, vs 20-30% pretax margins.  This business throws off honest-to-goodness free cash flow, even in bad times. 
Interestingly, one of the North American players in this little niche is owned by Berkshire Hathaway.  It's called PLM and it's part of Scott Fetzer, which Berkshire bought some 30 years ago.  The only other publicly-owned name is Macey, which is a tiny part of Cooper Industries (NYSE:CBE) and happens to be Minto's main competitor in Australia.  Everyone else is private.

Management is fairly guarded about details on Minto, so I've resorted to scuttlebutt to fill in the blanks.  Having spoken with lots of buyers and distributors I'm reasonably confident of the following:  Minto leads the market with something like 60-70% share, while Macey has perhaps 20-25%.  The remainder belongs to Ausproof and New Macey (run by the guys who founded the original Macey).  Sales to coal vs metal mines are split roughly 70/30.

While replacement parts are constantly in demand, the big driver for sales is expansion of mining activity.  I began the table below in FY04 as the industry veterans I spoke with tell me that year was the worst of the preceeding three decades for electric equipment sales to mining (the number of coal mines in Australia bottomed that year at 99).  Also, CMI finished a cost-cutting program that year.  Thus FY04 probably represents the low-end of expected profitability.  As for the high-end, we don't really know if last year's result will eventually be exceeded, but at this share price it probably doesn't matter.  

 FYE June 30
 '04  '05  '06  '07  '08
 Sales  15.6  23.6  31.8  49.3  51.9
 Depreciation  0.3  0.5  0.2  0.3  0.4
 Pretax profit
 3.3  5.9  9.0  15.0  14.9
 Tangible equity
 4.8  9.5  12.0  19.2  12.3
 ROTE  45%  58%  59%  67%  66%

 Notes: assumes 30% tax rate.  Tangible equity = equity less acquisition goodwill.  June '08 equity excludes $15M note due from sale of old auto parts business (since it's an unrelated asset).
 
Mining accounts for 45% of Electrical sales and probably a much larger percentage of profits.  I'd guesstimate that Minto is doing about 50% pretax margins. 


TJM and Capitalcorp
On July 1, 1999 Hofmeister bought TJM, a maker of 4WD automotive accessories (e.g. bull bars, differential locks, roof racks, etc.)  While CMI's traditional auto parts were fairly generic and sold to OEMs, TJM's are made for offroad enthusiasts and mostly sold in the aftermarket.  Unfortunately, TJM has not been a huge success thus far - sales have grown modestly from $36M in FY99 to $45M in FY08 and margins have been fairly thin.

On July 1, 2003 Hofmeister bought Capitalcorp, a loan broker specializing in financing for used cars.  This was an act of blatant diworsification, with predictable results.  Like the U.S., Australia also went through a bubble in consumer finance.  When it popped, so did the profits at Capitalcorp.


Enter Ray Catelan
Catelan is a self-made entrepreneur with a thing for deep value and activist investing.  Between 2006 and early 2008 he bought about 1/3 of the shares, cleaned house at the top, cut overhead, and sold the lousy auto parts company back to Hofmeister, using some of the proceeds to pay down debt.  Catelan also tried to spinoff or sell both TJM and Capitalcorp, but was basically thwarted when the credit crisis hit.

Recently, CMI sold a 51% stake in Capitalcorp in an MBO.  The business is losing money, but an aggressive restructuring should limit CMI's share of future losses to $2M max.  I value this between -$2M and zero, to be safe.

The company is keeping TJM for now, and there's a decent chance it could have significant value.  Australia is home to the world's best 4WD technology.  The leader in this market is a company called ARB (ARP AU on Bloomberg), which does a mid-20s ROE year after year with essentially no debt.  TJM is a distant second with less than 25% of ARB's sales volume and a roughly 5% ROE, while a private company called Opposite Lock is third.  The remaining half of the 4WD accessory market is highly fragmented.  If TJM could close even part of the performance gap with ARB it would really boost earnings at CMI.

4WD enthusiasts love talking about their trucks, and from what I can tell, TJM's products are well received by the marketplace.  So I think ARB's advantage is probably an operational one.  Scale obviously helps, but note that when its sales were similar in size (FY99), ARB had pretax margins in excess of 11% vs 3% for TJM today.   Getting to 11% would mean an extra $0.07 in EPS for CMI, which is a big deal for a $0.55 stock.  Under Ray Catelan, TJM has focused on improvements in design and manufacturing.  Time will tell how well they succeed.

In FY08, profits at TJM roughly offset losses at Capitalcorp.  So the valuation multiples I mentioned earlier are essentially based on just the results at Electrical.  It's like you get these other two for free.


Capital structure & valuation
Ex-Capitalcorp, CMI did about $0.31/share in FCF for FY08.  That's against an EV of $0.55 less $0.23 net cash plus whatever the Class A Shares are worth.  Briefly, the Class A Shares were issued years ago and are entitled to the first $0.14/share per year of any dividends paid, plus there's a liquidation preference of about $1.20.  The catch is that the Board has full discretion as to whether or not any dividends get paid, and it's non-cumulative.  The company discontinued the usual quarterly payment back in February and the Class A's sold off.  Then in September, CMI offered to buy all 28M Class A shares for $1 each.  The offer was to be put to a vote in November, but the company recinded the offer in late October, saying it didn't feel too comfortable taking on $28M of bank debt while the world's economy was going into tailspin. 

At $1 per Class A Share and 33.8M ordinary shares, that brings the total EV to $1.15/share, or 3.7X FY08 FCF.  Again, this ignores TJM and Capitalcorp, which taken together are roughly breakeven.


Outlook
I suspect that Catelan's game plan is to eventually take out the Class A's and start paying dividends to the ordinary shareholders.  In any case, I don't worry about dumb capex or acquisitions since Catelan has no sentimental attachment to this industry (he made his fortune in real estate/IT).  He's in this to make money.  By the way, the boardroom upheaval has not left this company short of expertise, as each of these businesses still has the same management teams in place. 

The second largest shareholder, Greg Nunn (aka Farallon Capital), is an entrepreneur who made his fortune in electrical equipment.  One of his main product lines was electrical substations for coal mines (a substation takes power off the grid and converts it for use).  Trust me, it's a small world when it comes to electric equipment for Australian mining.  Nunn bought in around the same time/price as Catelan and I'll bet you he knows this business pretty well.

Metaliferous (zinc, copper, etc.) mines are hurting in this recession, but demand from coal mines (~70% of coupler sales) has been holding up so far.  I'm not in the business of grand predictions, but let's just say that Australian mining booms historically don't end in just four years.  Compare that to what Japan and S. Korea did for Australia back in the '60s and '70s.  Also, China is somewhat larger than those countries.  In any case, we might not need a rebound to make money at this share price.















Catalyst

Purchase of Class A Shares, followed by big fat dividends
Operational improvement at TJM
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    Description

    Despite its size, CMI is interesting since it's so rare to find a fantastic business that has anything to do with mining.  Management is smart and shareholder-friendly.  And yes, it's really cheap:  the EV/FCF multiple is 3.7X on the year ended June 30, 2008.  FY09 will be a tougher year, so perhaps the forward multiple rises to 6 or so.  Plus you get a couple of ancillary businesses which together are at breakeven today, but probably have real value.

    My apologies for the erratic liquidity in this name.  On a good day it's 250K shares, on a bad day it's zero.  The biggest buyer in the market is the new Chairman of the Board, who recently bought a third of the equity around $1.20/share and is adding more all the time.

    CMI was founded in 1991 by Max Hofmeister as a rather unremarkable Australian auto parts company.   When that industry fell into secular decline, Hofmeister tried to acquire his way out of the problem.  Along the way, he regularly overpaid both himself and his buddies on the Board. 

    Unlike the rest of his shopping spree, the electrical component makers he bought have actually worked out quite well.  These are Peaston (1997), Heartland (1998), Minto (1999), Aflex (Oct 2004) and XLPE (July 2006) - collectively, the "Electrical Division."  For the most part, the products are cables and connectors designed for specializedindustrial use under harsh conditions.

    Minto - the cash cow
    Minto makes couplers for the mining industry.  Modern mines use lots of electricity and have miles of electric cable running all over the place.  Couplers are specialized devices that connect one cable to another, or to the machine that's using the electricity.  This rather prosaic bit of equipment turns out to be a very lucrative niche for a few reasons:
     
    1. Couplers take a lot of abuse, and when one breaks, the true cost to its owner is not so much the money spent on fixing/replacing the coupler as it is the lost productivity of all the miners and equipment who are sitting idle while repairs are under way.  The latter is many times the former.  As a result, mines tend to use only one brand so that they're more likely to have the necessary spare parts on hand, and so that their guys are totally familiar with the equipment.  Some really big mining operations dual-source, but some don't.  Since couplers are only a tiny part of total costs, buyers are not price sensitive.
    2. There's also a safety issue:  the air in a mine often contains potentially explosive gasses like methane - particularly in coal mines (hence the proverbial "canary-in-the-coal mine").  If an electric spark were to ignite this gas, you'd get a big explosion that can kill up to dozens of miners.  Thanks to product improvements and very strict government regulation, Australia has not had a major incident of this sort since the mid-1980s.  The desire to keep it that way makes buyers even less price sensitive - nobody's going to risk people's lives and their own career on some untested brand just to save a little money.
    3. These factors combined lead to yet another positive:  a near total absence of foreign competition.  Because miners want to always have spare parts on hand, the lead times on overseas orders become a real problem for them.  Further, Australian electrical standards are unique and government approval is hard to get.  Hence, Australia just isn't an attractive market to anyone overseas.  For a North American supplier, you'd be looking at re-tooling your production lines and slogging through the approval process just to enter a market that's only one tenth the size of your own.  And you'd still have the issue with long lead times.  The same would apply to anyone in China, even if they overcame buyer concerns about product quality.
    4. Finally, the business isn't capital-intensive.  Capex/depreciation is about 1.5% of sales, vs 20-30% pretax margins.  This business throws off honest-to-goodness free cash flow, even in bad times. 
    Interestingly, one of the North American players in this little niche is owned by Berkshire Hathaway.  It's called PLM and it's part of Scott Fetzer, which Berkshire bought some 30 years ago.  The only other publicly-owned name is Macey, which is a tiny part of Cooper Industries (NYSE:CBE) and happens to be Minto's main competitor in Australia.  Everyone else is private.

    Management is fairly guarded about details on Minto, so I've resorted to scuttlebutt to fill in the blanks.  Having spoken with lots of buyers and distributors I'm reasonably confident of the following:  Minto leads the market with something like 60-70% share, while Macey has perhaps 20-25%.  The remainder belongs to Ausproof and New Macey (run by the guys who founded the original Macey).  Sales to coal vs metal mines are split roughly 70/30.

    While replacement parts are constantly in demand, the big driver for sales is expansion of mining activity.  I began the table below in FY04 as the industry veterans I spoke with tell me that year was the worst of the preceeding three decades for electric equipment sales to mining (the number of coal mines in Australia bottomed that year at 99).  Also, CMI finished a cost-cutting program that year.  Thus FY04 probably represents the low-end of expected profitability.  As for the high-end, we don't really know if last year's result will eventually be exceeded, but at this share price it probably doesn't matter.  

     FYE June 30
     '04  '05  '06  '07  '08
     Sales  15.6  23.6  31.8  49.3  51.9
     Depreciation  0.3  0.5  0.2  0.3  0.4
     Pretax profit
     3.3  5.9  9.0  15.0  14.9
     Tangible equity
     4.8  9.5  12.0  19.2  12.3
     ROTE  45%  58%  59%  67%  66%

     Notes: assumes 30% tax rate.  Tangible equity = equity less acquisition goodwill.  June '08 equity excludes $15M note due from sale of old auto parts business (since it's an unrelated asset).
     
    Mining accounts for 45% of Electrical sales and probably a much larger percentage of profits.  I'd guesstimate that Minto is doing about 50% pretax margins. 


    TJM and Capitalcorp
    On July 1, 1999 Hofmeister bought TJM, a maker of 4WD automotive accessories (e.g. bull bars, differential locks, roof racks, etc.)  While CMI's traditional auto parts were fairly generic and sold to OEMs, TJM's are made for offroad enthusiasts and mostly sold in the aftermarket.  Unfortunately, TJM has not been a huge success thus far - sales have grown modestly from $36M in FY99 to $45M in FY08 and margins have been fairly thin.

    On July 1, 2003 Hofmeister bought Capitalcorp, a loan broker specializing in financing for used cars.  This was an act of blatant diworsification, with predictable results.  Like the U.S., Australia also went through a bubble in consumer finance.  When it popped, so did the profits at Capitalcorp.


    Enter Ray Catelan
    Catelan is a self-made entrepreneur with a thing for deep value and activist investing.  Between 2006 and early 2008 he bought about 1/3 of the shares, cleaned house at the top, cut overhead, and sold the lousy auto parts company back to Hofmeister, using some of the proceeds to pay down debt.  Catelan also tried to spinoff or sell both TJM and Capitalcorp, but was basically thwarted when the credit crisis hit.

    Recently, CMI sold a 51% stake in Capitalcorp in an MBO.  The business is losing money, but an aggressive restructuring should limit CMI's share of future losses to $2M max.  I value this between -$2M and zero, to be safe.

    The company is keeping TJM for now, and there's a decent chance it could have significant value.  Australia is home to the world's best 4WD technology.  The leader in this market is a company called ARB (ARP AU on Bloomberg), which does a mid-20s ROE year after year with essentially no debt.  TJM is a distant second with less than 25% of ARB's sales volume and a roughly 5% ROE, while a private company called Opposite Lock is third.  The remaining half of the 4WD accessory market is highly fragmented.  If TJM could close even part of the performance gap with ARB it would really boost earnings at CMI.

    4WD enthusiasts love talking about their trucks, and from what I can tell, TJM's products are well received by the marketplace.  So I think ARB's advantage is probably an operational one.  Scale obviously helps, but note that when its sales were similar in size (FY99), ARB had pretax margins in excess of 11% vs 3% for TJM today.   Getting to 11% would mean an extra $0.07 in EPS for CMI, which is a big deal for a $0.55 stock.  Under Ray Catelan, TJM has focused on improvements in design and manufacturing.  Time will tell how well they succeed.

    In FY08, profits at TJM roughly offset losses at Capitalcorp.  So the valuation multiples I mentioned earlier are essentially based on just the results at Electrical.  It's like you get these other two for free.


    Capital structure & valuation
    Ex-Capitalcorp, CMI did about $0.31/share in FCF for FY08.  That's against an EV of $0.55 less $0.23 net cash plus whatever the Class A Shares are worth.  Briefly, the Class A Shares were issued years ago and are entitled to the first $0.14/share per year of any dividends paid, plus there's a liquidation preference of about $1.20.  The catch is that the Board has full discretion as to whether or not any dividends get paid, and it's non-cumulative.  The company discontinued the usual quarterly payment back in February and the Class A's sold off.  Then in September, CMI offered to buy all 28M Class A shares for $1 each.  The offer was to be put to a vote in November, but the company recinded the offer in late October, saying it didn't feel too comfortable taking on $28M of bank debt while the world's economy was going into tailspin. 

    At $1 per Class A Share and 33.8M ordinary shares, that brings the total EV to $1.15/share, or 3.7X FY08 FCF.  Again, this ignores TJM and Capitalcorp, which taken together are roughly breakeven.


    Outlook
    I suspect that Catelan's game plan is to eventually take out the Class A's and start paying dividends to the ordinary shareholders.  In any case, I don't worry about dumb capex or acquisitions since Catelan has no sentimental attachment to this industry (he made his fortune in real estate/IT).  He's in this to make money.  By the way, the boardroom upheaval has not left this company short of expertise, as each of these businesses still has the same management teams in place. 

    The second largest shareholder, Greg Nunn (aka Farallon Capital), is an entrepreneur who made his fortune in electrical equipment.  One of his main product lines was electrical substations for coal mines (a substation takes power off the grid and converts it for use).  Trust me, it's a small world when it comes to electric equipment for Australian mining.  Nunn bought in around the same time/price as Catelan and I'll bet you he knows this business pretty well.

    Metaliferous (zinc, copper, etc.) mines are hurting in this recession, but demand from coal mines (~70% of coupler sales) has been holding up so far.  I'm not in the business of grand predictions, but let's just say that Australian mining booms historically don't end in just four years.  Compare that to what Japan and S. Korea did for Australia back in the '60s and '70s.  Also, China is somewhat larger than those countries.  In any case, we might not need a rebound to make money at this share price.















    Catalyst

    Purchase of Class A Shares, followed by big fat dividends
    Operational improvement at TJM

    Messages


    Subjectclosing position due to price appreciation
    Entry02/05/2011 04:18 PM
    Membermpk391
    fairly valued, thus I'm out
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