Bradken's new deal

After rejecting a suite of takeover offers – we count at least four – Bradken is now investigating a proposed merger with Chilean business Magotteaux, a firm which manufactures grinding media. The terms of the proposed merger are unknown just yet but two things are clear: the merged entity will remain listed on the ASX and the market has reacted with venom.

The share price has halved over the past month but we suspect this is a reaction to uncertainty about the price and structure of the deal rather than a verdict on its merits. It is possible Bradken will have to make a cash or equity contribution to the merger.

Assuming 5% EBITDA (or earnings before interest, tax, depreciation and amortisation) margins for Magotteaux implies $50m of operating earnings, a sum that should support an enterprise value of around $400m and suggests that, with Bradken's cash resources meagre, a deal could involve a lot of new shares being issued. If that happens, savage dilution will be hard to dodge.

Nothing has been approved yet so all this is speculation. Bradken has made a habit of attractive bids without consequence but, in our view, this one is likely to stick.

Separately, Magotteaux's parent company has combined with CHAMP private equity to inject $70m of cash into Bradken, relieving balance sheet pressure by reducing net debt to $350m. Convertible preference shares are redeemable by Bradken in 2020 and include steep penalty rates for non-redemption so this is essentially a loan rather than a means of seizing control.

Some advantages

There are no signs of improving industry conditions so a recovery will take time but Bradken retains some advantages. About 80% of costs are variable so margins have been maintained even as revenues have fallen. Unlike the rest of the industry, Bradken has not had to defend vulnerable margins.

Many of its products are made using the same factories and components so a change in product mix – making fewer rail carts and more engineered products for example – is helping mitigate the downturn. The business has also been shutting high cost manufacturing plants in Australia in favour of lower cost plants overseas. There are still half a dozen foundries in Australia that could close to further lower costs. Management is reacting to lean times.

That doesn't mean a recovery is imminent. The share price may go lower if Bradken needs to raise equity to fund the merger. As investors sell in anticipation of a capital raising, the more dilutive that raising will be if it comes.  

Like the rest of our mining services mini portfolio, this idea isn't suitable for everyone and carries very high risk. We recommend just a 1% position as a deeply contrarian speculation. For that purpose, Bradken remains a SPECULATIVE BUY.