Description

I am recommending an investment in Legend Corporation Limited (ASX: LGD).  I have sized this to about a 6% position given already sizable exposure to Australia, but I would consider going higher.

Company Overview

The company, headquartered in Australia, designs, manufactures, imports and distributes for the local market a variety of electrical-oriented products, including connectors, tools, cables, measurement instruments, wiring and HVAC items.  Legend supplies both direct end customers and electrical wholesalers throughout the entire country.  Through its distribution channels, the company supplies both company owned brands like CABAC and third party national and international products.  Legend’s entry into HVAC distribution was through the recently acquired Systems Control Engineering business (SCE).  The company now conducts business through three segments: (1) Electrical, Power and Infrastructure, (2) Innovative Electrical Solutions and (3) Gas and Plumbing.  Electrical, Power and Infrastructure is the largest business, producing approximately 87% of revenue and 41% of operating profit in the most recent year.  Innovative Electrical Solutions, a higher margin business, produced 16% of revenue and 40% of operating profit.  Gas and Plumbing was acquired at the very end of the year and will make a full year contribution for the first time in the current fiscal year.

Thesis Summary

An investment in Legend Corporation provides an opportunity to invest at a very low multiple to FCF along-side an owner operator running fairly attractive businesses and demonstrating a solid level of M&A competence.  The recent acquisition of SCE seems particularly attractive.  Recent headwinds with the declining Australian dollar have negatively impacted margins, obscuring the potential underlying cash generative capability of the company.  And while the end of the resource boom has further pressured revenues, Legend fundamentally remains a highly cash generative business with prospects for modest organic growth and further acquisitions.

Why Does Opportunity Exist

• Small-cap Australian companies are not exactly the most favored asset class at the moment.  Pressure on the Australian economy has especially impacted sentiment on smaller companies.

• The end of the commodity boom has impacted Legend, as it has a variety of businesses in Australia.  While there are no precise numbers available, in part due to distribution through wholesalers where the end customer information may not be precisely known, the company estimates that at points it could be greater than 20% of the business (prior to recent declines and prior to the SCE deal).

• Margins have been under pressure given the sizable import component of the business.  Declines in the Australian dollar have pressured operating margins which have fallen from 14% in fiscal years ’11 and ’12 to 10.5% in fiscal ’15.  Guidance suggest a bit of an additional decline in fiscal ’16.

• A meaningful difference between D&A and actual cap ex needs has consistently provided a FCF tailwind relative to NI.  This appears to be ignored.

• Liquidity is somewhat limited given that A$50 mm market cap and the sizable ownership stake of the company’s CEO, Brad Dowe.  Currently he owns approximately 28.4% of the company.

Management and Incentives

• Legend Corporation is run by Bradley Dowe, who founded the business with his wife in their kitchen in the early 1990s.  Today he owns 28.4% of the company, worth A$15.6 million at our acquisition price.  His base salary is about A$.33 million and so his stake in the company is worth 47x his annual salary.  Last year he received A$1.1 million in dividends, or more than 3.3x his annual salary.  Needless to say, we think we and Dowe are on the same side.

• Dowe has built the business through a series of acquisitions, deftly repositioning the company away from the legacy operation that was destined for complete failure.  Originally, when the company listed in 2004, it was a manufacturer of computer memory products, which it sold to OEMs.  This business eventually ran into significant competitive pressures as Asia emerged as the dominant low-cost supplier to many of the world’s computer manufacturers.  Dowe repositioned Legend through a series of acquisitions, completed at attractive prices, in the electrical distribution space it occupies today.  

• The most recent acquisition, completed toward the end of fiscal ‘15, was a company called System Control Engineering (SCE).  I believe the acquisition will continue Dowe’s history of attractive deal making.  At the total maximum purchase price, the company will have paid a multiple of 4.7x earnings before interest and taxes.  

• Brad Dowe understands his shares are not valued attractively as a currency.  This is an issue the company hopes to address.  We would expect him to remain disciplined in avoiding equity dilution at these prices.  

Additional Notes

• Six acquisitions since 2006 have been concluded to reposition the business away from the terminal legacy business.  By my count, the company paid a bit under 5x EBIT (not EBITDA) for 5 of the six transactions.  The remaining acquisition was a very small select asset purchase for which little detail was provided.  Including the recent acquisition of SCE, it would appear that collectively the company hasn’t necessarily grown these businesses as the acquired revenue approximates the current run-rate.  However, given the prices paid and the declines in the resource boom, I consider this an acceptable performance.

• I believe the SCE deal will prove to be quite attractive.  In and of itself, the 4.7x EBIT multiple (which includes all contingent deferred consideration) is attractive, but the company has additional potential levers to reduce SCE’s working capital intensity and increase margins, which combined could reduce the multiple to 3.3x.  With creditor days running at 20 days and inventory running about 1/3 of sales, the company sees scope to reduce the BS by about $3-3.5 mm over the 12 months post transaction.  Further, given significant physical distribution overlap and sales per employee that are far lower than the core Legend business, there are significant cost opportunities estimated to be at least $1 mm.  In our judgment, the market is not paying attention to, among other things, this attractive acquisition.

• FCF was negatively impacted by two discrete factors in fiscal ’15.  The company had to make a change to the timing of tax payments which negatively impacted cash flow by $1.3 mm.  Further, a conscious decision was made to expand the company’s inventory investment, primarily in the Innovative Electrical Solutions business.  This impact is estimated at perhaps $1 mm.  Slower sales in the Electrical, Power and Infrastructure business also left stock holdings a bit higher than desired.  Reducing inventory is a particular focus of the company at this point, and operating cash flow guidance provided at the AGM suggests the company is making progress.  Average inventory as a % of sales rose to 26% in fiscal ’15 which is up from the high teens a few years ago.  This might imply $5-6 mm worth of elevated inventory.

• Legend Corporation’s business is fairly attractive when returns are measured against a variety of inputs.  On a tangible equity basis, the company has returned 40% on average since 2008.  Return on equity has averaged 13% during that period and return on tangible assets has averaged 12.7% over that period.

• Relative to many distributors, and attributable to the owned brand and innovative products that Legend designs and sources internally, the company boasts fairly attractive consolidated margins, with underlying pre-tax margins averaging 9.8% since 2008.  

• We see some scope to recover some margin over the next couple of years, as the rapid decline in the Australian Dollar during the last two years has been a headwind for margins.  Underlying pre-tax margins peaked at 13.2% in 2012 before falling to the mid 9% range recently.  The company estimates that the impact on operating income due to the decline in the AUD in fiscal ’15 was $1.7 mm.  This would be about 1.5% of sales.  The potential primarily would be driven by the Electrical, Power and Infrastructure segment.  The segment which was nearly 90% of sales in FY ’15 has seen pre-tax margins decline from an average of 8.1% (since FY ’07) to 5.1% in FY ’15.  On A$80 mm in sales there is some meaningful potential here.  On the other hand, this must be tempered to an extent by the much smaller Innovative Electrical Solutions segment which has been performing very well and saw record margins in FY ’15.

• While a headwind from the decline in the Australian mining boom appears to have softened the business, we don’t believe the market is paying attention to the improving market for home construction in a country that needs additional supply.  Recent statistics suggest this has been occuring as the country reallocates resources away from the mining sector.  (http://www.abs.gov.au/ausstats/[email protected]/Latestproducts/8731.0Main%20Features2Sep%202015?opendocument&tabname=Summary&prodno=8731.0&issue=Sep%202015&num=&view=) While recent approvals have perhaps softened, and the trend has been more prevalent in multi-family (which may be more difficult for Legend to capture), this should be a bit of a positive for the business as residential and commercial construction has historically been the company’s largest end market.  

• At year end fiscal ’15, the company had $21.2 mm of net debt against $11.1 mm of EBIT… so just under 2x EBIT.  With the cash flow guidance provided at the AGM, net debt should be under $20 mm at the end of the upcoming half year.

• Recent guidance provided at the AGM was for the first half to be admittedly a bit softer than I expected.  At the mid-point of the guidance, the company would produce $3.2 mm in net profit.  With the addition of SCE and depending on the assumption regarding amortization and incremental interest from that transaction, this may imply an organic decline of perhaps 20% on operating income as the continuing impact of the large decline in the AUD if felt.  While hard to judge, organic revenue could be down perhaps 8% or so.  With that said, operating cash flow is guided up 25% and the company still expects full year NI to be above fiscal ’15.  Recent increases in prices to combat the exchange rate should begin to more fully impact the business going into the New Year.

Valuation, Potential Return and Downside Protection

• Shares currently trade at 0.75x book value and 5.9x my estimate of fiscal ’16 FCF.  FCF is estimated at approximately $8.5 mm comprised of $7.1 mm of net income and a $1.4 mm difference between D&A and capital investment.  

• Since 2009 FCF has averaged $7.7 mm.  Inclusive of SCE this rises to perhaps $8.7 mm.  At today’s prices you are paying 5.7x averaged FCF.  If we look at FCF, excluding working capital changes, the figure is $8.3 mm rising to $9.3 mm with SCE.  At today’s prices you would be paying 5.4x that figure.

• If one assumes the company regains 50% of the lost underlying pre-tax margin on fiscal ’15 revenue, Legend would produce nearly $10 mm of FCF, enough to reduce the multiple of free cash flow to 5x.

• Shares are currently yielding 7.5%.

• With a re-rating in the free cash flow multiple to just 12x, some modest organic growth and another acquisition or two over the next five years, I see a triple as the upside possibility.  At 12x FCF this would require $12.5 mm in FCF.  At the current rate of $8.5 mm that would require an additional $4 mm of FCF.  This could come from: (1) modest organic growth now of a re-based business, (2) recapture of pre-tax margin and (3) acquisitions.  If we assume $8.5 mm in annual cash flow (which doesn’t grow), $3.8 mm in dividend payments and a capital structure that isn’t further levered with transactions, Legend could deploy $23.5 mm in transactions over the next five years adding perhaps $4 mm in EBIT at even a 6x EBIT multiple which would be above historic trends.  This would add $2.8 mm in approximate FCF before any additional leverage, organic growth or margin recapture is considered.

• Trading at below book value and such a low multiple to current and average FCF would suggest the downside is fairly well protected.  If you assume a 10x FCF multiple to equity would be fair if it were to further suffer and then stabilize, FCF would have to fall over 40% more from $8.5 mm to $5.0 mm before a potential loss of capital.  If you assume that in such a scenario you could only hope to get the current multiple of 6x, then downside could approach 40%.  Leverage seems manageable, though not without its risks in a scenario where volumes and margins continue to suffer.  While I always look for my downside to be well-protected (and I believe it is in this case) regardless of the upside, I believe an analysis of the upside relative to the downside scenario is quite positive.

Potential Catalysts

• Ongoing high levels of fully franked dividends.  At recent prices the shares are yielding 7.5%.  This should prove sustainable and attractive to potential Australian owners of the shares.

• Further acquisitions are a distinct possibility.  With the track record of well-priced acquisitions, this should prove to be value accretive.

• The company delivering on its full year guidance of improved net earnings for the full year, providing some evidence that the worst of the degradation in performance is behind them.

Risks

• Future acquisitions may not be as attractively prices as historically has been the case or as I perceive they might be.  Additionally, acquisitions may not deliver intended benefits and fail to be properly integrated.

• While I believe the debt load of the company is not a problem, significant additional declines in margins and sales could lead to a situation where debt levels become uncomfortable.  Dividends in the scenario would obviously be a first thing to examine which can often be a negative catalyst for shares.

• The thesis is predicted in part on a strong owner operator.  As such key man risk as it relates to Brad Dowe is a concern.  It is unclear if there is an identified competent replacement.

• Further meaningful declines in the Australian dollar may very well pressure margins further.  While the AUD has already declined from over parity with the USD to around $.70 cents, the end of the resource boom may further pressure the currency.  More aggressive upside scenarios are dependent on some margin recovery which may not be possible.

• Margin pressure in the Innovative Electrical Solutions business may emerge, especially as we are coming-off historically high margins.

• A large percentage of Legend’s business is conducted through electrical wholesalers.  These are generally smaller business in Australia that have failed to adapt as quickly as someone like Legend would like to things like internet capability and the growth in residential multi-family construction.  The electrical wholesale channel may be considered strategically weak and could further be challenged by additional and expanded internet oriented distributors.

• The Australian economy may continue to be further pressured by end of the commodity bubble.  While conditions have already softened in a material fashion, additional macro-economic risks remain.

• Recent pricing actions may not be fully absorbed by customers.  Volume may suffer from the pricing initiatives.

• The company isn’t accurate in that full year net income exceeds fiscal ’15, either from further volume pressure or further exchange rate pressures.

Catalyst

• Ongoing high levels of fully franked dividends.  At recent prices the shares are yielding 7.5%.  This should prove sustainable and attractive to potential Australian owners of the shares.

• Further acquisitions are a distinct possibility.  With the track record of well-priced acquisitions, this should prove to be value accretive.

• The company delivering on its full year guidance of improved net earnings for the full year, providing some evidence that the worst of the degradation in performance is behind them.