Recently in the Wall Street Journal I read that Australia’s LNG industry is on track to overtake Qatar as the biggest exporter of the fuel by 2017. From the companies that I have come across in the recent past, Monadelphous Group (ASX:MND, MOPHY) immediately came to mind. The stock trades on the Australian Securities Exchange and trades OTC in the United States. The company first showed up on a screen of mine for growing companies with high returns on equity and capital, a high earnings yield, and trading at a discount to its earnings. The reason why Monadelphous came to mind is that it was working on LNG projects. Back in February, the company secured a $680 million construction contract at the Ichthys Project Onshore LNG Facilities. The stock was halted during the announcement, and the stock increased about 20 percent during the following two weeks. As I took another look into the company, it is a part of almost all of the major LNG projects in Australia. For engineering and construction companies, RCR Tomlinson (ASX:RCR) is also trading at a bargain, but it does not have the large LNG exposure that Monadelphous has.
Company Background
Monadelphous is a leading Australian engineering group that provides construction, maintenance and industrial services to the mining, energy and infrastructure sectors. The company started operating in 1972 providing general mechanical contracting services to the mining industry. In the late 1980’s, a major restructuring of the company took place with the business refocusing on maintenance and construction services in the resources industry. In 2012, Australian Financial Review’s BOSS magazine named Monadelphous as Australia’s most respected company in the construction sector.
The company operates in two main divisions, Engineering Construction and Maintenance and Industrial Services. The company reports in halves and for the latest half, Engineering Construction generated 75 percent of the revenue and Maintenance and Industrial Services generated 25 percent of the revenue. The markets that are served include oil and gas, water, coal, power, iron ore, and mineral processing. A majority of the revenue comes from the iron ore (37.8%) and oil and gas (36.1%) industries. Oil and gas revenue is on its way to overtake revenue from the iron ore industry. In the report six months earlier, iron ore represented 39.5 percent of revenue and oil and gas represented 26.9 percent of revenue.
Financial Strength
Monadelphous scores 7/10 for financial strength. It has a very strong balance sheet with a cash balance of $234.6 million. The net cash balance (cash less interest bearing loans and borrowings) is $188.1 million. The company generates enough operating revenue to cover its interest expense 53.90 times.
The company scores 7/10 for profitability & growth. Management has been very effective at generating returns on invested capital. The return on capital is 156.28 percent and the return on equity is 49.62 percent. Along with an earnings yield of 16.10 percent, the stock would be a perfect match for Joel Greenblatt’s Magic Formula if it included foreign stocks.
Although the company has had strong internal returns, a slowdown in capex spending by the large mining companies has slowed down revenue growth. Management saw the slowdown coming in 2013 and viewed 2013/2014 to be a consolidation period. In the latest semi-annual report, revenue was down about 1 percent and earnings increased 10.1 percent. Since the company saw the slowdown coming, management was able to maintain positive earnings by instituting a company-wide cost reduction program that resulted in a savings of $34 million. It also sold its non-core aviation support business, Skystar, for a $10.4 million pre-tax profit.
Management
The company still has the same Chairman and Managing Director in place that has helped the company throughout its fast growth period. The Chairmen, John Rubino has been on the board since 1991 and was the Managing Director until 2003 when Rob Velletri was promoted to the position. Since 2003 revenues have grown from $155 million to $2.6 billion for the last twelve months. The management also has the ability to forecast a slowdown in its customer base and realign the company to keeps its profits growing.
Valuation
The stock is trading at a low P/E of 9.30, and its median P/E for the past 15 years is 15.6. Its 5-year median P/E is at a similar reading of 15.4. The stock would be trading at $26.40, if trading at its median P/E. It is currently trading at $16.41, a 37.8 percent discount.
For the trailing twelve months, Monadelphous had earnings of $1.79 per share. Using the GuruFocus DCF Calculator with a default discount rate of 12 percent, earnings would only have to grow at a rate of 2.52 percent to justify the stock’s current price. If the company were to maintain its recent 10 percent earnings growth, the stock would be valued at $25.22, with a 36 percent margin of safety.
Risks
Revenue has dropped for the first time since 2008 and the mining industry has been cutting back on capex spending in Australia. Iron ore producers are the largest customers of Monadelphous, and the price of iron ore has been in a downward trend since 2011. Prices have fallen 31.7 percent year-to-date. Iron ore produces, such as Rio Tinto and BHP Billiton, have high enough operating margins to withstand further drops in the price.
Another concern is the large reduction in employees over the past year. The number of employees was reduced by 25 percent in one year. The company says that it was done in line with slowing construction activity and key talent retention remains high. The concern is if construction activity picks up, will the company be able to attract the highest quality employees after laying off such a large percentage of its workforce. Monadelphous is on the other side of the globe, so I do not have a feel for their workplace environment, but large lay-offs tend to bring a large amount of negativity to the work environment.
Outlook
Monadelphous is good value trading at only 9.30 times earnings and paying a steady dividend that currently yields 8.2 percent. The large drop in iron ore prices has slowed down its revenues from its largest customers, but oil and gas revenues have been making large gains. Australia is expecting to be the largest LNG exporter within the next few years and Monadelphous has a large role in the construction and maintenance of the facilities. Oil and gas revenue is on track to pass revenue from the iron ore industry and help the company bring back revenue growth. Management had the ability to foresee the slowness and made the reductions in expenses to maintain net income growth. The company has been able to continue its earnings growth by diversifying its customer base and will be able to grow at a faster pace once the cyclical iron ore industry turns around.
Technically, the stock has been trading in a range between $15 and $20 for a little more than a year. The stock is near the bottom of the range and provides a good entry point. With the stock at the low end of the range, trading at a low P/E of 9.3, and providing dividend that yields 8.2 percent, the downside is likely minimized.
*The currency unit for this article is the Australian dollar. As of 7/24/2014, the exchange rate is 1.06 AUD/USD.
