All in the timing at Clough
Recommendation
The ancient Greek poet Hesiod said it first and said it best: the right timing is, in all things, the most important factor. We were literally minutes from publishing our views on mining services company Clough this morning when news of a takeover offer was released. No doubt Hesiod would approve of our impeccable timing, even if it did produce howls of agony from your analyst and mocking mirth from his colleagues.
Clough's major shareholder, the South African engineering group Murray & Roberts, has offered to buy the remaining 38.4% of Clough they do not already own for $1.46 per share, a 31% premium to yesterday's closing price. That price will be paid with a cash component of $1.32 per share plus a $0.14 fully franked dividend. Clough's board has responded enthusiastically to the offer and, after analysing the business, we concur. As detailed below, this is a poorly performing business. Shareholders should gratefully take the bidders cash.
There is, superficially at least, plenty to like about Clough. For one thing, it holds almost $180m in cash and no debt. Then there’s the fact the largest LNG construction boom in history is underway in Queensland and off the Western Australian coast; Clough already earns the bulk of its revenue from LNG projects and is one of the few companies in the sector to upgrade earnings this year.
Key Points
- Accept takeover offer
- Cash flow badly lags profits
- Without Forge contributions, Clough makes no money
Is Clough a rare exception from the industry rout? Peer closer and flaws become more evident. By 2015 the current crop of LNG projects will be complete and we doubt any new project will be undertaken in Australia for a decade. The LNG boom is coming to an end.
Harsh reality
Although its balance sheet looks healthy, earnings from Clough are far worse than they appear to be. As Chart 1 shows, reported profits and cash flow are worlds apart. The reason lies in the accounting for Clough’s revenues, which are booked as progress is made on projects rather than when payment is made. The result is lumpy cash flow and deceptively smooth profits.
Follow the money
Cash flow lagging accounting profits is a common feature in the industry, although the difference in this case is particularly stark. Another concern comes from where profits are being generated within Clough.
The company has now sold its 36% stake in Forge (which is why it’s flush with cash) but the equity stake had been a major source of both profits and cash flow over recent years. Clough booked almost $70m in profits in both 2011 and 2012 from its Forge holding while reporting profits of $33m and $43m respectively. Without the contribution from the Forge holding, Clough’s own business lost money.
The cash flow statement confirms this. Over the past two years, Clough has been paid about $85m in dividends from Forge. Exclude those payments and you get negative gross cash flow of $15m in 2012 and $30m in 2011. That it is cash flow positive at all owes itself to payments from Forge which won’t be forthcoming next year. Although Clough paid dividends of $17m in 2011 and 2012, such dividends aren’t supported by cash flow. They will likely continue to be paid out of Clough’s cash pile, but they aren’t sustainable.
Low margins
Clough has been flattered by its Forge holding, while its own business doesn’t appear to generate much value for shareholders. Comparing Clough's normalised earnings before interest and tax margins to its peers clearly shows that Clough earns far less than it should and, in recent years, it has been losing money (see Table 1).
FY2008 | FY2009 | FY2010 | FY2011 | FY2012 | |
---|---|---|---|---|---|
Clough | 2.9 | 9.3 | -9.7 | -8.5 | -3.4 |
Ausenco | 9.9 | 3.6 | -0.9 | 6.9 | 9.2 |
NRW Holdings | 11.4 | 11.7 | 9.8 | 8.8 | 11.4 |
Forge Group | 7.6 | 10.2 | 17.2 | 13.7 | 9.0 |
Decmil Group | 3.4 | 7.3 | 8.5 | 8.6 | 10.3 |
Monadelphous | 9.7 | 9.1 | 9.1 | 9.3 | 9.1 |
Source: Capital IQ, company accounts |
Although there is scope to improve EBIT margins towards the industry average, it’s hard to believe this will happen while demand contracts sharply. Clough is a fine example of a business that appears resilient – with a cashed-up balance sheet and increasing profits – but scratch the surface and the enchantments disappear. If you’re looking for discarded quality, you won’t find it here.
Murray & Roberts is displaying plenty of ambition with its bid. No doubt the company thinks it can lift Clough's ailing EBIT margins towards industry standard. There is a greater chance, however, of industry margins falling to meet Clough's. A contracting market is no time for heroics; perhaps Murray & Roberts should read some Hesiod. If you're a shareholder in Clough, consider yourself lucky. ACCEPT OFFER.