PMP: repair and despair

Value investing is a hard game at the best of times but it has rarely been more difficult or less rewarding than now.

To do it well requires not only sharp analysis but also psychological traits that few possess. If there is one virtue that binds all value investors it is patience. We all understand that, while the market may be mostly efficient, it is also exuberant, manic depressive and overly short sighted.

Exercising patience and taking a long-term view is among the few advantages left to the individual investor.

When does patience become stubbornness? When does it become a shield from admitting an error? These are the questions to ask regarding PMP, one of our long-standing - and most disappointing - recommendations.

In the beginning

To recap, we first recommended PMP way back 2015 in PMP: back from the brink and the investment case was rather specific. After years of losses, PMP had restructured and cut its operations and was, for the first time, generating free cash flow.

With surplus capacity, PMP was depreciating its asset base heavily but it didn't need to spend much on capital expenditure so it was generating high free cash flows. Those free cash flows could, we argued, be used to buy a competitor and lead to a rationalisation of the industry and, finally, higher margins.

Most of that worked out exactly as hoped. PMP and listed competitor, IVE Group both used free cash flows to dramatically change the industry structure: five competitors became two and all that was left was to integrate by raising utilisation rates and lifting margins.

The wrong horse

IVE, for its part, has done exactly that. It acquired two competitors and doubled earnings before interest, tax, depreciation and amortisation (EBITDA) margins in the process. PMP has followed the same map but ended up in a very different place.

The integration of PMP and IPMG, the industry number two, hasn't gone to plan. Costs have been difficult to cut and PMP has dramatically lowered profit expectations from the merger. The idea, so far, hasn't worked.

The market has been savage in its response. After leaping to 80 cents after announcing the deal, PMP now limps below 20 cents with a market capitalisation of just $100m and $32m in net debt.

For an enterprise value of $132m, we get a business generating $40m in EBITDA. On paper, the EV/EBITDA multiple of just over 3 times appears cheap but there remain concerns.

This year's results are among them. Admittedly riddled with restructuring and redundancy costs, they featured negative operating cash flow and a pre-tax, normalised return on capital of just 3%. The final EBITDA was less than half what was originally expected when the merger was first mooted and there is no obvious path back to those levels. These are appalling numbers and may well suggest low multiples are well deserved.

Old habits die hard

On top of the poor numbers, there's a worrying new development. After swearing off new capacity for years, both IVE and PMP are now buying big, expensive new printers.

PMP announced it would add a fancy industrial printer at a cost of $20m. IVE has added two similar assets to its suite so one can argue that PMP simply needs to be able to match the lower operating cost of its competitor.

The new printer is expected to reduce operating costs and will replace existing machines. Buying expensive new assets certainly hasn't harmed IVE which, as we noted, has reported another year of strong results.

This highlights a key weakness of the business. Our investment case relied on lower industry capacity and higher utilisation to lift margins. That has happened. PMP has closed facilities and aggregated work. This should, in time, raise margins for PMP just as it has for IVE.

Yet who keeps the benefit of that efficiency gain? So far, IVE and PMP have had to plough cash back into their businesses even though there is no capacity shortage. It's likely that savings will ultimately be pocketed by customers in the form of lower prices rather than by shareholders.

Jump at shadows

We've had a fair go at PMP seeing it through success, troubles and despair; it hasn't worked out. With merger woes still fresh, perhaps it will if we are prepared to be patient. Yet should a poor-quality business with disastrous returns on capital, poor economics and strong competitors and customers be the recipient of our patience?

This is the true lesson from PMP. Value investors are right to point to patience as a key advantage; yet having it and wielding it are two different things.

For a decent quality business, patience pays. For a business with the unfortunate characteristics shown by PMP - high capital intensity, cut throat competition, low returns on capital and possible disruption - there need to be limits to our patience.

In fact, we would have been better served being far less patient and more panicky. Perhaps, when it comes to the lower quality end of the market, value hounds ought to jump at shadows rather than exercise zen-like calm.

So - belatedly - that's what we are doing.

Time's up

There is no doubt PMP is cheap. Yet it was just as cheap at 60 cents and at 40 cents. Perhaps it will work out but we need to draw a line somewhere. Cash has an opportunity cost and patience must have limits lest it morph into plain stubbornness.

There are some encouraging signs from here and, for those who choose to stay on, higher catalogue volumes suggest this isn't a market in permanent decline just yet. We also hear that prices have stabilised and contracts are being rolled over without discounting. That's a good start.

But our case has run. The merger has happened, industry conditions have improved, capacity has been cut and utilisation has risen. PMP's key competitor has reaped the benefits and we have not. It's hard to identify what will now change to improve things.

Even with a much-improved industry structure, it has taken no time for competition to revert to a tit-for-tat cost battle. Both competitors have purchased expensive new assets despite ample spare capacity, suggesting that high historic free cash flows were a mirage.

Any surplus returns from this industry will be competed away and we have less confidence that will change will fewer competitors.

It is galling that so much has gone right yet still resulted in a large loss. If you bought at our initial recommendation, you'd be down about 60%; more if you bought higher. Yes, investing is a hard game. Wielding our patience with more care might make it a little easier. SELL.

Note: The Intelligent Investor Equity Income Portfolio owns shares in PMP. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in PMP.