Bradken: Interim result 2015

'Bradken withholds dividends', screamed one headline in the business press. Industry conditions are bleak and getting bleaker; revenue, profits and cash flow all sunk; yet Bradken's greatest sin – and the reason its share price fell 20% following its interim result – was the culling of its long-standing dividend.

Let's be clear about this: we applaud management for not caving in to the foolish demands of the market. Debt already sits uncomfortably high and cash is better deployed elsewhere in the business. Paying a dividend now would be folly. Shareholders ought to ignore the market's irrational condemnation and focus on the operational performance.

On that front, things weren't great but neither were they dire. Revenue sank 12% to $495m and underlying profits fell 64% to $14m – more than expected thanks to higher amortisation charges. Cash flow, a key plank in our investment thesis, declined 75% to $16m and free cash flow was negative compared to a surplus of $30m last year. Ouch. The numbers look bad but closer inspection reveals they weren't that bad.

Cash flow was affected by restructuring costs and higher inventory levels. Cash spent on redundancies and site closures is inevitable as manufacturing moves offshore and the business canned third party sales of some products in favour of direct selling to customers. Although this aids margins it also means inventory previously held by distributors is now on Bradken's own books. Cash flow should improve in the next half.

Higher volumes

The bulk of Bradken's business is the supply of consumables to miners, and is linked to production volumes. Although mining volumes did rise, producers are delaying maintenance and equipment purchases to preserve cash. They can't do that forever and there are faint signs behaviour is changing.

For the first time since the downturn began, the order book outstripped current sales. Uniquely in the industry, Bradken has maintained margins even as revenue has fallen. The company earned gross margins of 33.7% during the height of the boom and reported margins of 32.5% for the half year. Over 80% of the costs in the business are variable and the company is adjusting those costs to match lower revenues.

During the boom, Bradken built low-cost foundries around the world to replace small, high-cost foundries in regional Australia. Originally done to allow expansion, in the bust this has given the company access to low-cost output. High-cost foundries are closing – Bradken will shut two in the next six months – and there are still half a dozen Australian foundries that could close to lower costs again.

Margin stability also suggests that excess capacity doesn't need to clear and peers don't need to go bust before a recovery occurs. Lower revenue is the chief problem, a sign that today's pain is a classic cyclical downturn. While we don't believe the boom will return, current dire conditions aren't permanent.

Aggregated results also disguise that just a handful of products have been responsible for the bulk of revenue lost. Revenue from the rail wagon business fell 26% and a decline in the sale of crawler systems slashed mining products revenue by 13%. The consumables business was down by 9% while revenue from engineered products actually rose 6%. Changes in the sales mix could help restore profits.

Debt is too high

At $430m, debt remains high and a capital raising is still a risk, but the company is within its covenants. Bradken must maintain net debt/EBITDA at less than 3 times (it is currently at 2.5 times) and interest cover at greater than 3.2 times (it is currently at 6 times). As well as slashing capital expenditures – they fell a further 32% in the half-year – the business could also sell land worth about $100m.

The lower Australian dollar was the main driver of higher debt but the company has refinanced in local currency so US denominated debt now stands at just $125m. Although this is exposed to currency, significant revenue is sourced from the US to provide a natural hedge.

For the full year, Bradken should generate revenue of about $1bn and, assuming flat margins, operating profits should come to around $150m. Sustaining capital expenditure of $50m would mean the business should generate enough free cash flow to lower debt and invest in further cost savings. With Bradken's market capitalisation just $420m, the business still looks cheap and has more levers to pull as it adjusts to less buoyant conditions. So far, management has done all the right things.

Bradken remains part of our portfolio approach (See Time to buy mining services part 3) to the mining services sector but it isn't without risk. Demand remains low, debt is high and a capital raising could yet sink the share price again. There is plenty of risk, which explains why the business is so cheap. For those fishing for the cheap and the risky, Bradken remains a SPECULATIVE BUY.