Matrix Composite & Engineering Ltd (ASX:MCE) manufactures composite plastic products, mainly for the oil and gas industry. MCE has reported negative statutory earnings since 2015 and at the time of writing sells for less than half of book value. Sounds pretty ugly. However if we dig into the details a little more then we can see a few things that make MCE interesting:
- FCF has been positive during the past few years despite earnings being negative and revenue decreasing by >80% since 2014.
- It carries a large amount of deferred tax assets on the balance sheet.
- One large difference between reported earnings and FCF is the large amount of asset impairments booked since the price of oil tanked in 2014.
- Another large difference is that depreciation is typically >2x maintenance capex. When I think about the type of batch process that MCE uses then this makes sense, especially during times of reduced production volume.
It’s easier to see this laid out if we use as much financial data as we can get and do an Earnings Power Value (EPV) analysis. This avoids what I call ‘yes, but’ analysis. For example, yes MCE has high depreciation charges, but maintenance capex is a lot less. Or, yes MCE has ongoing R&D costs just to maintain their competitive position but they still have positive FCF. This drives me nuts – how can you possibly make a cohesive decision based on a series of statements like that? Better to lay it all out in a way which allows the individual charges to be connected to growth in sales (or not) and see what amount of earnings the company can distribute each year, over a series of years. Basically it allows us to see how the business works as a cash flow machine.
The first thing I want to point out is that I do things a little differently for different industries. MCE’s revenue is heavily cyclical and when revenue is falling off MCE tends to book a lot of non-cash impairment charges. This results in negative EBIT and hence MCE accumulates tax losses during these periods. I expect these impairments will be removed when the cycle is on the upswing so I add them back to EBIT. For a company which tends to make a lot of crappy acquisitions which then need to be written down permanently I wouldn’t add them back.
The other thing I did for MCE was to calculate an average EBIT margin by dividing the average revenue by the average EBIT across all the years for which we have data. This gave me an EBIT margin of around 5%. To see if I’m kidding myself I also tried entering an EBIT margin of zero and found MCE still generates positive distributed earnings. If you follow through the calculations you can see why; depreciation charges are a lot higher than what MCE pays in maintenance capex.
To estimate MCE’s maintenance capex I looked at their overall capex over the period for which data is available. From 2009 to 2012 MCE spent several tens of millions annually in capex. Since then it’s been on average about 4 million per year. Much of the spend up to 2012 was on land, buildings and equipment for MCE’s AUD 68MM plant. For the type of process MCE has I think around 6MM per year at most needs to be put aside for future equipment replacement (less during periods of low utilisation) so in the EPV calculation I’ve used this number instead of the calculated figure for maintenance capex from 2009 to 2011.
Looking through the historical data on the number of oil drilling rigs in use it looks to me as though the peak size of the industry is probably not going to be any larger than it was in the most recent peak cycle. So to calculate the EPV value for conversion to EPV/share I used the 10-year average of distributable earnings. If the company was likely to grow over time I might use the trailing 5-year figure or even the 1-year figure but I would want to have very clear reasons for doing that.
So that’s an example of how to do an EPV calculation. Does it mean MCE is a buy at the current price of about $0.46? Not on its own. But when I look at the lack of competitors and barriers to entry for this industry and the lack of debt on MCE’s balance sheet I think this is a good opportunity. Even if the price of oil goes nowhere, MCE’s products are subject to wear and tear and are installed in places (i.e. in the depths of the ocean or down an oil well) where maintenance is expensive and hence quality of components is paramount. Sales volume isn’t likely to drop much more and the market is unlikely to be flooded with competitors. I think it is a low risk way to get exposure to any possible increase in the oil & gas industry.
If you have questions or comments please write to Warwick at email@example.com. I answer every email that I receive. You may also like the previous article on Reproduction Cost which you can find here.
Disclosure: This is not a recommendation to buy or sell any securities. I currently own MCE. All information presented is believed to be reliable and is for information purposes only. Do your own research before purchasing any security.