Description

Key Points

• Very good business
• Core business pretax return on assets historically ranging from ~30-50% with very limited capex
• Significant barriers to entry, pricing power and defensible competitive position with extremely high switching costs in the core business
• Recurring revenue model with legal obligation to replace units every number of years
• Extremely reasonable current valuation at 5.5x my FY13E pretax income (which is very depressed – only ~4x FY12 pretax)
• Engaging with shareholders again - chairman will be on a roadshow next week and they will likely be instituting a dividend in 2013
• Very reasonable case for the business to trade over $6/share to earn 2.6x in ~2 years

CMI Ltd. was first written up in December 2008 by mpk391.  As with many things in Dec. 2008 it was ludicrously cheap.  The business is still cheap today due to a large amount of retained earnings over the past 4 years, cleaned up balance sheet, substantially larger installed base of electrical couplings, market share gains in Western Australia, attractive valuation and the quality of the main business. 

CMI started life as an Australian auto parts company whose founder enjoyed acquiring businesses outside his circle of competence.  He dabbled in such diverse industries as electrical components, aftermarket automotive accessories, and used car finance.  Eventually the market valued the stock as though it were a combination of crummy businesses with a crummy operator.  Unfortunately for him he didn’t install any good corporate defenses and Ray Catelan bought a third of the company between 2006 and early 2008. 

In a nutshell he fired management, reduced costs, sold the auto parts business to the original founder and began to pay down debt.  He additionally tried to remove (spinoff or sell) the non-electrical businesses but his timing in late 2008 was poor.

For a long time a class of preferred stock in the capital structure (non-cumulative elective dividends, non-voting) confused investors since these senior securities traded at distressed levels (because a non-paying non-accruing instrument with no teeth is terrible) and this complicated the situation.  

Sadly, Ray Catelan passed on and is no longer with us.  The business is now being run as a more normal listed company.  Little was done until now to tell the story of the business qualities and improvements which have been made.  They have subsequently redeemed the complex preferred shares, begun releasing presentations, guided for a 2013 dividend, etc.  Basically it is trying to act like a more typical listed company and should probably be valued as such.

Electrical Division – Cash Cow

The Electrical division is the value driver for CMI which is quite capably managed by general manager Jeff Heslington.  Within Electrical is Minto, a gem of a business which I believe by itself is worth approximately the value of CMI.  The remaining piece of the electrical business (XLPE and custom cabling) is a bit boring but quite valuable relative to the current market cap. 

Before you read any further – please read the MPK writeup of the business from December 2008.  It is excellent in quality and results.  If you’re like me – you’ll be attracted to the idea that the competitive position and economics of the core business haven’t changed since then.

I’ll wait

For those of you who didn’t read it I’m quoting him here since he did such a good job explaining the Minto business

“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.”

And I would also quote some of the excellent market dynamics he cited

“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 dualsource, 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 "canaryinthecoal 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 mid1980s. 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 retooling 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.”

Additionally, it is mandated by law that these underground mine couplers be replaced every so often (I’ve heard 5 years for most of the equipment) to ensure optimal safety conditions as they wear out.  This is because the principal feature of a Minto coupler is spark/flame suppression, and that is REALLY important in underground coal mines from the standpoint of the operator/government/contractor installing electronics/employees, etc. (http://www.nytimes.com/2013/02/12/world/europe/russia-explosion-in-coal-mine-kills-at-least-17.html?_r=0)

As such, the current installed base of couplers provides some amount of future recurring revenue as does every installation in a new mine.  I have heard that their market share is in the range of ~60% for what they do.  In 2012 around ~½ of their sales likely went into new mines and mine extensions while the other ~½ were recurring in nature as either old couplers broke or were mandated to be replaced for safety reasons. 

The mining boom of the last number of years has created a much larger installed base of equipment than existed in the past in underground thermal and met coal mines that we can service/replace for a LONG time.  Plus, the way underground coal mining works, mines are pretty much always expanding the tunnels to pull out their product which can require more electrical equipment.  

For anyone who’d like to see a quick tour of a simple underground coal mining – link below.  There are multiple types of equipment used to dig as well. 

http://science.discovery.com/tv-shows/how-do-they-do-it/videos/how-do-they-do-it-coal-mining.htm

So coal mining (which is currently very challenged in Australia) does not need to be expanding for Minto to make sales and profits.  But it certainly does help and importantly grows the installed base of couplers so any improvement in coal will be a major catalyst.

Even in the current coal environment (which is terrible) I still think Minto can produce ~$7m of EBIT in FY 13 despite miners delaying huge components of their discretionary costs (I guesstimate they did $12m of EBIT in their FY ended 6/12 - so this would be a pretty substantial decrease).  There is a risk it could be worse than that but if so I think it’d be very temporary as the installed base is finite life and must ultimately be replaced as long as mines stay open.  I do not believe that the market appreciates the quality or durability of this business even in the current environment.

But coal investment is unlikely to be low forever and if/when it normalizes the results can be very exciting as we can incrementally earn extremely high margins selling razors to kids  just entering puberty (new coal mines) with a very long lived annuity component.  The headlines are terrible but over time this business is more resilient because of its installed base and dominant market share.  There is substantial upside from any increase in activity from thermal and met coal.

Apart from Minto, the electrical business has the XLPE, Hartland, and Aflex business.  These are less incredible but do a fine businesses from a return on capital and equity standpoint (unclear exactly how good they are though because of limited/guarded disclosure on margins across the segment).  They are also run by the same highly competent general manager.    

The larger of these is XLPE which principally supplies imported electrical cabling to the building and construction industry, selling mainly to distributors (as opposed to end customers).  It appears to have grown modestly in recent years.  The smaller Hartland and Aflex cabling perform custom cabling and are relatively labor intensive.  They basically perform small jobs with a high degree of variability and low operating leverage.  They have both been around a long time and sound pretty steady.

These businesses are much less incredible from a qualitative standpoint but I think could still be capable of producing as much as~10m pretax contribution in FY 13.

The electrical division as a whole had historically has returns on ASSETS in the ~30-50% range and seems to deserve a high blended multiple as such given the above characteristics.

TJM – Turnaround Option

TJM is a 40 year old company focused on the sale of SUV accessories (http://www.tjm.com.au/ - be sure to check out the videos).  Its all the accessories you need to take your 4 wheel Nissan out in the Australian outback (or look cool parked in your office lot/impress those outback ladies).  About ½ their sales are aftermarket mainly through a TJM domestic store network, with the rest of sales split between OEM sales and exports to other distributors.  The biggest product category is bull bars (they go in front of your SUV) followed by winches, suspension, and differential locks.

This business was previously run by Ray Catelan’s nephew who I’ve heard was totally incompetent.  My understanding is that his prior background was as a welder and while I have nothing against welders that was a pretty big promotion.  He left when Ray passed and the business is now under professional management.  Apparently the brand still has goodwill in Australia but I haven’t focused on this segment.  A nice result might have $4m of EBIT in 2-3 years but it could also keep muddling along.  Revenue for the latest half was up ~9% YoY which is encouraging however the costs of reorienting the business are causing results to lag on a bottom line basis.  The business lost ~600k pretax in the last half and I would expect next year to be about breakeven.  While I’m skeptical it does sound like there is a lot of low hanging fruit for new management.  This isn’t the main event in any case, and while the business probably employs ~22m of net assets I’d value it at less than that to be conservative.

Corporate Costs

Corporate costs are extremely minimal running at about ~2-2.5 million with the principal operational management existing at the subsidiaries (where management is quite good).

Valuation

• Minto in my estimation can do between 7 and 12 million pretax today in a bad/good year but those numbers should naturally trend up over time.  With exceptional returns on capital and business characteristics it is not unreasonable for the business to be worth between ~70-100 million standalone (vs. a current market cap of ~85m)
• That high multiple would be based on pricing power, recurring revenues, large barriers to entry, incredible ROA, low capex and natural growth drivers
• The other electrical divisions in my estimation appears capable of earning about ~10m pretax in the current environment.  They also have good returns on capital and the same solid management so these might be worth ~50-75m
• TJM – Australians seem to like this because of how well people have done in their competitor’s stock (ABR) over time.  Its employing about 29m of assets and has ballpark ~22m tangible equity.  Let’s say its worth something in the range of ~15-20m.
• Corporate running in the low 2s but let’s capitalize 2.5 at a 7 multiple and say -17.5m.

Using the midpoint on the sum of those valuations would give CMI about 78% upside

Another way to think about this is that if you come back in two years, CMI will probably have produced about $20m of cash and could well have improved earnings to ~20-24m pretax (normalization of coal/ageing of the current installed base and decent results in the rest of electrical).  Maybe they’ll even maybe a couple million out of TJM.  In case this sounds like a pipe dream they made 21m of pretax income in FYE 6/12 and we will have a substantially larger and older average age installed base of couplers at this point and I believe that FYE 6/13 will probably have them earn something on the order of 15m pretax in very a tough environment with coal miners deferring costs.

If the business were valued at 9x those types of pretax profits plus cash generated it could be worth ~$6.4/share or 2.6x the current price.  That valuation would seem reasonable for a business with some of the above mentioned characteristics.

Catalyst

• Coal price/investment rising
• Re-rating by the investment community in light of the business quality
• Company continuing to tell story (Chairman on a roadshow shortly to present results)
• Commencing a dividend in 2013 and beyond

Risks

• Leanne Catalan is a director and 37% owner of the business.  She is Ray’s daughter but so far she appears to be allowing the company to do shareholder friendly things
• Resignation of the new independent director the other day.  I haven’t spoken with the director who left
• Chairman’s latest share grant was, in my opinion, structured with inappropriately favorable terms
• Coal prices/investment declines further
• TJM doesn’t turn around/begins to lose money
• Competitive pressure at the non-mining electrical businesses
• Australian $ (but that could sort of goes both ways with their coal industry)

DISCLAIMERS

• I have an ownership interest in CMI Ltd. at the time of this write-up that can change at any time without notice. There are no plans to provide future updates on the authors buying or selling activities for this or other stocks. The author may buy or sell shares of CMI Ltd. without notice for any reason at any time.

Catalyst

• Coal price/investment rising
• Re-rating by the investment community in light of the business quality
• Company continuing to tell story (Chairman on a roadshow shortly to present results)
• Commencing a dividend in 2013 and beyond