Update on CMI Limited (ASX:CMI)

I’m going to write two updates on a couple of Australian holdings that were the subject of earlier posts on the blog. Today’s post is about CMI (ASX:CMI)

I wrote about CMI in 2015 and the investment has been a disappointment so far. My thesis was that the company’s electrical division, which specializes in the sale of specialty electrical cables, plugs and couplers used in underground mining, was depressed due to the downturn in mining, but would remain valuable and would stand to benefit in a mining recovery.

The latest preliminary final report for fiscal year 2017 do show some signs of life, with revenue up almost 9% year-over-year. However, pre-tax profit was $5.6m, basically flat year-over-year.

I still think this part of my initial thesis is sound. CMI’s electrical segment has high quality products that are essential in underground mining operations. Capital expenditures are low and this division should generate significant free cash flow if mining and industrial revenue demand recovers. Electrical EBIT was $15-$20m from 2011-2013 and shows the potential for this segment. I don’t think there’s a structural problem with CMI’s electrical products and that its depressed results are (still) due to tough industry conditions. There’s little detail in the preliminary report though, perhaps the annual report can provide a better picture of the challenges the division is facing.

CMI’s surprise

What I got wrong though was my evaluation of management. Leanne Catelan was a major CMI shareholder and held 38% of the shares at the time of my original post. Towards the end of 2016, CMI made a surprising announcement. It proposed to turn itself into an investment company and $20m of its excess cash was to be invested by a money manager called Michael Glennon. Glennon was to become a 50% owner and share in the management fees of the newly created subsidiary, Excelsior Asset Management. He would also become a CMI director.

I looked at a fund that Glennon was managing and didn’t really like what I saw. He didn’t seem a value oriented investor to me. Also, the strategy that was proposed for managing CMI’s $20m didn’t make much sense. There was talk of taking an activist approach and taking “controlling stakes” in companies, but also that there would be a “diversified portfolio” that would “initially comprise of up to 20 securities”. These statements are contradictory. With a portfolio of $20m it is impossible to take controlling stakes or become an activist in companies and to be diversified at the same time.

This change in business required a shareholder vote. Shareholders who didn’t like the prospect of turning CMI into this new direction were offered a buyback for 10% of CMI’s outstanding shares at a price of $1.25 per share. Leanne Catelan would not participate in the offer. The tender offer was made at a large discount to book value. CMI’s directors themselves said that the market value at the time did not reflect the true value of the business. Shareholders really weren’t being offered a fair deal here, in my opinion.

Unfortunately the vote passed and Excelsior Asset Management is now a 50% owned CMI subsidiary and managing CMI’s excess cash. As a foreigner I was not able to participate in the tender offer. The tender offer was followed by more selling of shareholders who now wanted out. The share price dropped below $1.00 in early 2017.

Why?

I’m still not entirely sure why CMI chose to take this path. I do have a theory. By turning a large part of their company into an investment portfolio, it pretty much guarantees that this part of the business will trade at a discount to its book value in the market. An inadequate market price is not something that most public companies would want. Leanne Catelan was able to increase her ownership level with this tender offer by buying out shareholders at an inadequate price. She now has effective control of the company. I think that by turning a large part of CMI into something akin to a closed-end fund, she has guaranteed that this part of the business will always trade below its book value. This should allow CMI to continue to buy back shares at depressed prices in future tender offers and buybacks and will ultimately allow Catelan to delist the company or take it private at a low price. This explanation makes the most sense to me, because the main person who has benefited from all this so far is Leanne Catelan. Michael Glennon is the other beneficiary of course. Why was he selected to manage CMI’s cash? I have no idea.

Maybe there is no controversy here at all. Perhaps Leanne Catelan honestly thinks Glennon is a great money manager and that turning CMI’s cash over to him will maximize the market value of CMI for all its shareholders.

Shareholder friendly?

Here are a couple of quotes from my CMI write-up:

Australian entrepreneur Ray Catelan was a major shareholder of CMI Ltd and was managing director from 2007 until 2011. He owned about 37% of the shares. Mr. Catelan passed away in 2011. Not long after, CMI was sued by an investment fund called Trojan Equity, which had a large holding in the Class A shares of the company. CMI had stopped paying dividends on the Class A shares even though is was required to do so. The management wanted to save cash to fund acquisitions. There was also controversy around a cash gift made by Mr. Catelan to his daughter Leanne that was subsequently used by her to buy a block of shares of CMI. Some discussion about this legal case can be found here. In fiscal 2012 CMI bought back the A shares for $26m.

And:

The fact that the company is willing to return cash is positive on two levels. It gives an indication that minority shareholders will be treated fairly, something I was a bit doubtful about after reading about the lawsuit by Trojan Equity and the purchase of a block of shares by Leanne Catelan.

I think we can safely conclude that I was wrong about Leanne Catelan. I was aware of the controversy around the cash gift made by her father and felt that it was a bad way to act. Should I have let this fact weigh more heavily and let it stop me from investing? Perhaps. At the time I thought it was too early to conclude how Leanne Catelan would treat minority shareholders. The fact that CMI was returning cash to shareholders was a positive sign. After the tender offer and the creation of Excelsior, I have a much more negative view about Leanne Catelan’s attitude towards minority shareholders.

CMI today

I think CMI’s intrinsic value is substantially lower today than at the time of my write-up, given the events that have followed. It seems less likely today that CMI’s minority shareholders will ever get a price for their shares that fully reflects the value of the business. The risk of CMI delisting and/or buying out shareholders at a low price has increased.

That said, I still own my shares. I just felt that the selling pressure earlier this year created such a depressed price that it didn’t make sense to sell. Even now, at a share price of $1.10, the entire company is selling for $34.5m and 0.74x book value. The company has around $23m in cash and investments (which deserves a discount) on the balance sheet and no debt. The electrical division is still profitable and generating cash in depressed industry conditions. I think they should be able to show much better results at some point.

CMI has definitely been a disappointing investment for me so far. The company did pay a capital return of $0.30 per share after my write-up and several small dividends along the way. I think it totals $0.42 per share, so the decline from the $1.65 price at the time of my post is not as great as it seems at first glance. The opportunity cost should also be considered though.

I’m still holding my shares for the time being and waiting for a recovery in CMI’s electrical division. I think that should still offer good upside from the current share price.

Disclosure: long CMI Limited (ASX:CMI)