Opportunity on the scrap heap

Where there’s muck there’s brass, the saying goes, but try telling that to shareholders in Transpacific Industries. Australia’s largest waste management business has seen its shares tumble from over $14 in 2007 to just $1 today. To prove the value of the saying, though, we’ve found an opportunity amidst the wreckage.

Of course the problem wasn’t ever with the muck; it was an overenthusiastic management hell-bent on expansion. As is often the case, it all began with a good idea. Waste management is largely a fixed-cost game – costs don’t change much if you stop at one house or fifty on your route, you still have to pay the driver, own the truck and manage the disposal.

So there are economies of scale to be had for the larger operators, but management got carried away, paying too much for too many companies, with too much debt. And they found that operational and financial leverage also works in reverse: as the economy slowed in 2009, a slight fall in demand saw the bankers called in.

Since then Transpacific has been in rebuilding mode, so it would be wrong to judge the business on its past mistakes. Management has been replaced and founder Terry Peabody has left, with hedge fund Warburg Pincus now owning 34% of the business.

Wasteful management

Layers of wasteful management have been stripped out, routes have been redesigned and costs have fallen. After a few capital raisings the balance sheet is looking a lot cleaner. Asset sales have also helped, and Transpacific recently made its last major disposal, selling its trucking business for $219m.

Net debt has fallen from over $1.6bn in 2010 to less than $800m today (see Chart 1). It’s a trend that’s likely to continue. Dividends have been halted and more discipline has been applied to capital spending, leaving more cash to reduce debt. Over the next few years another $300m should be paid off, leaving net debt around $500m – at which point we expect dividends to resume.

Underneath all this, the muck has delivered its brass throughout. Returns on tangible capital, for example, have average over 13% over the past 10 years – a perfectly decent return that highlights the benefits of scale. Waste demand continues to rise along with the economy and although around 20% of Transpacific’s business is exposed to the resources sector it’s a more resilient business than many appreciate.

We were initially attracted to company’s ordinary shares but, following a recent spike in the share price, there isn’t enough value on offer right now. The stock is up 37% since 27 Nov 12 (Avoid – $0.73), but we’re upgrading to HOLD. At about 75 cents we’d consider making it a Buy.

Up step the SPS

We’ve been watching the preference shares a tad longer, since Friday Fishing: Transpacific SPS from 09 Mar 12 (No View – $84.00), and our concerns have diminished along with the debt.

The SPS – technically ‘Step-Up Preference Securities’ – were issued in 2006 to fund the company’s NZ acquisition. Having passed the ‘step-up date’ in 2011, they offer a 6% margin over the 90-day bank bill swap rate, which sits very close to the cash rate and is currently 2.6%.

Better still, as they currently trade at a 5% discount to the face value of $100 (or about 8% excluding the fully franked coupon of $3.18 to which the stock will lose its entitlement on 24 September). This gives the stock a gross running yield of 9.5% paid half-yearly in a combination of cash and franking credits. There’s also a chance for a 9% capital gain if they are ever redeemed – this becomes more likely as Transpacific’s business improves but we won’t expect any action for the next few years.

Still, it’s the fine print that counts. And the SPSs offer limited comfort here (see Table 1). Perpetual, deferrable, preference shares are a flawed concept. At face value such ‘hybrids’ are rarely, if ever, attractive. They offer equity-like risks with fixed upside.

This is why we’ve cautioned against almost every recent issue (see Old-time banker studies Caltex Notes from 06 Aug 12 (Avoid – $100), APA and Crown Sub Notes a hard sell from 16 Aug 12 (Avoid – $100) and ANZ CPS3: A three strike failure from 05 Sep 11 (Avoid – $100)).

No guarantee

These are little different. We’re at management’s discretion as to whether distributions are paid. So far, even during 2009, they’ve continued to flow, which offers some comfort but no guarantee. These are not bonds nor a term deposit. But the risk of payments being cancelled falls as debt falls. Indeed operating cash flow covers the SPS coupon payments by more than 10 times – earnings would have to fall a long way before there was a hint of problem.

In an environment where interest rates are at record lows, and the underlying financial strength of the business is improving, we’re willing to take on those equity-like risks to get equity-like returns of 9.5% plus the potential for a small capital gain.

The Transpacific Step-up Preference Securities are a BUY up to $96, but note that we will adjust this down a touch after the stock trades ex its accrued coupon on 24 September. We also recommend being patient; this stock can be thinly traded on some days and it's not worth chasing the price up beyond our Buy price.

Note: We’re adding 60 Transpacific Step-up Preference shares to the Income Portfolio at $95.37 for a total cost of $5,722.