Preview: Company 3 is an Australian microcap trading at a single digit multiple of free cash flow and normalized earnings. Business conditions have been somewhat subdued and this has led to a market valuation that I see as attractive currently. Insider ownership is substantial and capital allocation by management has been intelligent.
Article type: Portfolio position, the author is long at the time of publication.
Legend Corporation is an Australian distributor of electrical products to the electrical wholesale industry. With their latest acquisition, the company has also started servicing the HVAC industry. The company distributes products like: cable accessories, connectors and cable assemblies, custom semiconductor integrated circuits, fibre optic cabling products and HVAC products (burners & boilers, fittings, thermostats, etc.).
A financial snapshot of the company:
Share price: $0.185 AUD
Shares outstanding: 218.32m
Market cap: $40.4m AUD
Book value: $68.5m
Net income fisc. 2016: $5.2m
TTM underlying net income: $5.4m
Free cash flow fisc. 2016: $8.0m
At the current price of $0.185, Legend is trading at 7.8x fiscal 2016 net income, 7.5x trailing twelve months underlying net income and just over 5x fisc. 2016 free cash flow.
The business has three segments:
- Electrical, Power and Infrastructure
- Innovative Electrical Solutions
- Gas and Plumbing
I’ll discuss the recent results for these three segments below.
Electrical, Power and Infrastructure
Results for fiscal 2016 were somewhat subdued due to reduced demand from power utilities, which impacted the segment. Profit was down 15%, because these utilities were restructuring their operations and deferring capital works. Operating profit for fiscal 2016 was $3.6m, down from $4.3m in 2015.
The downward trend continued in H1 of fisc. 2017, with revenue down 7% and operating profit down 10% to $1.4m.
I don’t think the reduced revenue and profit for this segment indicate any operational problems, my impression from the annual reports is that this is more a cyclical phenomenon. Legend sees some opportunities for the segment:
There are however several major infrastructure works near commencement that should provide a very strong pipeline of opportunities.
Source: Legend Corp. 2016 annual report, page 10
Demand has not picked up yet though, as the results for the segment in H1 2017 showed.
Innovative Electrical Solutions
The Innovative Electrical Solutions saw a demand spike from a major customer in fisc. 2015 that was not repeated in 2016. The segment returned to historical levels of sales, according to the company. EBITDA for the segment was therefore down 34% from 2015 and segment profit was down $2.2m, from $6.2m in fiscal 2015 to $4.0m in 2016.
The first half of fisc. 2017 saw a 14% improvement in profits to $1.1m, compared to $0.9m for the last six months of fisc. 2016, although revenue was down 15%. Management has been reducing overhead expenses, given the lower activity levels.
Gas and Plumbing
The Gas and Plumbing segment is the newest segment and was created after the acquisition of System Control Engineering (SCE) in May of 2015. This segment has lower margins than the other two. A major reason for Legend to purchase SCE was that management saw opportunities to realize significant cost savings ($1m a year) and to reduce the historical working capital needs for this business, thereby freeing up cash and effectively reducing the purchase price.
After a year of Legend ownership, the effects of the cost savings are now showing. Cost savings of 13% have been realized in the latest six month period. Segment profit has improved from $0.5m in H1 2016, to $0.8m in H2 2016 and $1.3m in H1 of fiscal 2017.
Below is an overview of the financials for Legend for the last six years:
It shows that business has been more difficult in the last few years, with revenue leveling off and margins sliding. Management offers this explanation:
Our markets have been challenging in recent years due to the major decline in Australian resources engineering construction, the declining dollar and the deferral of capital works by power utilities. The Australian dollar has now stabilized and there are major infrastructure works underway, or in the pipeline, that should provide opportunities for our business.
Source: Legend Corp. 2016 annual report, page 18
I don’t think these are permanent problems and believe that the business environment will improve eventually and perhaps a stabilized Australian dollar will lead to improved margins as well.
Legend Corporation now has half a dozen subsidiaries. Legend makes acquisitions quite regularly, but not at a frantic pace. It does take the time to digest a substantial acquisition and pay debt down somewhat before making another one. For example, Legend’s latest acquisition was System Control Engineering (SCE). SCE was purchased in May, 2015 for $10m upfront and an additional earn-out of up to $8.7m.
The company took on some debt to make the acquisition, resulting in net debt of $21.2m at the end of fisc. 2015, against $13.1m at the end of fisc. 2014. The past year was used to integrate SCE and to realize the cost savings from the acquisition. Net bank debt at the end of fisc. 2016 has come down to $17.9m, as the company used its operating cash flow to pay down debt.
It seems likely that more acquisitions will be made in the future:
We continue to investigate complimentary acquisitions that will deliver enhanced shareholder returns.
Source: Legend Corp. H1 2017 report, page 9
An investor in Legend therefore has to be confident that management will make sensible acquisitions.
Let’s take a look at the SCE acquisition and how this has developed. This quote is from the 2016 annual report:
EBITDA for the year was $2,148,000 up 30% on 2015 had SCE been owned for the full financial year.
Source: Legend Corp. Annual Report 2016, page 22
EBITDA has increased from $1.65m to $2.15m in fisc. 2016. The company mentions in its H1 2017 report that the integration of SCE is now complete. Expected cost savings for the full year are in excess of $1.0 million.
The company expects that the full value of the contingent consideration ($8.7m) will be paid out:
The SCE Group achieved the Earnings Before Interest and Tax (EBIT) target for the 6 months ended 30 June 2016 and a second deferred payment of $1,000,000 is due 31 August 2016. […] The payments are contingent on the achievement of EBIT targets each year. EBIT targets are combined for both System Control Engineering Pty Ltd and System Control Engineering NZ Limited. The current EBIT forecasts indicate that the SCE Group will achieve all targets and accordingly the full value of the remaining deferred consideration has been recognised. A net present value of $6,955,000 is recognised as a liability using a discount rate of 5.9%.
Source: Legend Corp. Annual Report 2016, page 43
Management expects a more profitable second half of fisc. 2017, partly driven by SCE:
We expect the profit in the second half to improve on the underlying profit achieved in the first six months driven by continued growth in SCE and improved results from Innovative Electrical Solutions.
(Bold text mine)
Source: Legend Corp. H1 2017 report, page 9
SCE reported operating profit of $1.3m in H1 2017 and management expects growth. If they are able to grow operating profit to $1.5m in the next six months and they are able to sustain this level of profit, then the maximum purchase consideration ($18.7m, including all earn-outs) would give this acquisition a 6.2x EBIT multiple. That looks like a reasonable multiple already. As the earn-outs run through August, 2019 and have EBIT targets associated with them, the company apparently expects that SCE can still increase EBIT meaningfully from current levels. The achievement of higher EBIT levels would make the SCE acquisition even more attractive.
The acquisition of SCE looks quite successful to me and this, combined with the large ownership position of the CEO (see below), gives me confidence that the company will make sensible decisions when evaluating future acquisitions.
Management & Insider ownership
Legend was founded in 1989 by Brad Dowe. Mr. Dowe is still the CEO today and he owns 63.3m shares, or 29% of the total shares outstanding.
He has made a couple of small on-market and off-market buys at $0.23 and $0.21 per share in November, 2016. Dowe received $469k in total compensation in fiscal 2016 (2015: $392k). At the current market price, his shares are valued at $11.7m. This high level of ownership by the founder and CEO creates alignment with the company’s shareholders.
The other three directors collectively own about 5.6m shares or around 2.5% of the outstanding shares.
Legend announced a share buyback on December 10, 2015:
Managing Director Brad Dowe said: “The buy-back is an effective means of returning capital to shareholders whilst the directors see the company’s share price trading much below the underlying value of the company. Legend expects the buy-back to be earning per share accretive, funded from existing cash reserves and debt facilities and will be prudently managed to maintain appropriate balance sheet capacity to fund further acquisitions”
In the end the company only managed to buy back $0.2m of stock. The limited liquidity of the stock makes it pretty difficult to buy back shares in the open market, I think. It does show that management considers the intrinsic value of the company in making capital allocation decisions. The directors also believed that shares were trading “much below the underlying value of the company” when the market price was $0.23 at that time, while shares are currently trading at $0.185.
Perhaps the management will consider a tender offer at some point. That would be one way that allows the company to buy-in a meaningful amount of stock at an attractive price.
Exposure to housing market?
The results for the Electrical, Power and Infrastructure is partly tied to residential and commercial building approvals. Australia has seen a major housing boom, driven by a natural resources boom and Chinese demand. Now that prices for natural resources have tumbled, prices and demand for real estate could suffer and building activity could slow down. I don’t know how much this could impact the results for this segment and for Legend as a whole.
Results for the Electrical, Power and Infrastructure segment are already depressed due to reduced demand from engineering construction associated with resources, and low expenditures on power networks by utilities in the last couple of years. It is possible we’ll see engineering construction and power networks spending go up, offsetting a possible decline associated with lower residential and commercial building activity.
Legend is a pretty boring business, trading at a single-digit multiple of normalized earnings. The business produces solid free cash flow. I believe shares have gotten this cheap, because operations have been somewhat depressed and earnings have been impacted by a few one-time items. This is also a micro-cap with a sub-50 million dollar market cap and a low float, due to the large ownership position of the founder and CEO. Few investment funds will be able to invest in a small stock like this, because it simply doesn’t move the needle for them.
Legend will probably look to do more acquisitions, but at the current price, buying their own stock through a tender offer makes a lot of sense to me as well. I think the CEO is shareholder friendly and (at least) a reasonable allocator of capital, so I would not be surprised to see a future tender offer, provided the cost of doing a tender warrants this. Management has already indicated that they thought their stock was undervalued when the stock price was substantially higher than it is today.
With some patience, I think the business will show improved results and I believe this will ultimately be reflected in the stock price as well.
Latest thoughts: August 2018
Last week, Legend released its results and the annual report for fiscal 2018. The business finally showed a nice uptick in revenue and profits. Revenue increased 15% to $114.9m. Of this increase, $8.7m was attributable to Celemetrix Group, a business that was acquired in March 2018. Net income was up 60% to $6.0m, but excluding an impairment of $1.1m in fiscal 2017, earnings were up 25%.
The newly acquired business Celemetrix is a fibre telecommunications test equipment and test & measurement calibration business. The acquisition price was $10.4m, but this has since been adjusted downward by $2.0m as earnings targets were not met. This was explained in more detail following a question on the company’s first ever (I believe) conference call. The company disagreed with the selling party about the near-term earnings prospects for fiscal 2018. That is why they built in a clawback clause of $2m. It now turns out that Legend’s management was right and the sellers were a bit too optimistic about the short-term results. I think this clawback is another indication that Mr. Dowe is a good capital allocator. He is a disciplined buyer and does not want to overpay for a business for the sake of empire building. It also means that the Celemetrix business performed according to Legend’s expectations so far. In this case the clawback does not indicate a problem with the acquisition, but purely reflects a difference in opinion about the near-term results between Legend and the sellers. At this time, Legend expects Celemetrix will meet the targets that are set for the earn out payments over the next couple of years.
The share price was up ~17% initially after results were announced, but they have drifted down a bit since then. At the current price of $0.26, the company’s market cap is $56.3m and the P/E ratio is 9.4. Legend’s management was positive about the outlook for fiscal 2019, expecting revenue growth and improved profits. If the company can grow revenue a bit and taking into account a full year contribution from Celemetrix, next year’s earnings might be
close to $7m. Edit: this number now seems far too pessimistic. Earnings for fisc. 2018 included only a 4 month contribution for the Celemetrix business, which generated a profit of $0.895m in that period.
Even though the stock price is up ~40% since this post was first published, I think the stock is still quite cheap. A high single digit earnings multiple for a cash generative business with a good capital allocator at the helm seems like a good deal to me. The true “owner earnings” of the business are higher as well, because most of the amortization charges do not reflect economic reality.
This quote from the earnings presentation was also interesting:
As advised to shareholders in the presentation at the AGM on 28th October 2016 and lodged with the ASX, the board has retained Gresham Advisory Partners to conduct a strategic review of Legend’s business. This review is ongoing and Gresham is actively investigating strategic options to create shareholder value.
Perhaps Legend’s management is open to the idea of a sale of the business? That would be a scenario that would probably get shareholders full value for their shares. In the public market, shares might continue to sell at somewhat depressed levels. I don’t think that’s the worst thing in the world as long as the management keeps increasing the value of the business. I’ve been very happy with their performance on this front.
Latest thoughts: September 2018
Legend posted a trading update today with some very good numbers for the first two months of fiscal 2019. EBITDA is up ~70% from last year, revenue increased 28% and gross margins have increased slightly. On a like for like basis, EBITDA is up 60%. Legend also announced another small acquisition of $2.6m. The stock is up 23% today.
I’ve decided to now make this post available on the public blog. Legend’s share price has almost doubled since this post was published, a year and four months ago. The shares still look reasonably attractive to me, even after today’s increase. That said, Legend was already my largest position by some margin before the share price started showing signs of life in August, so at some point I will probably have to sell a bit to keep the position size reasonable.
Disclosure: the author was long Legend Corporation (ASX:LGD) at the time of publication
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