Over the past few months the Forager Australian Shares Fund has been buying shares in Cardno (CDD), an engineering consultancy company. Gerry Cardno and Harold Davies started the business in Brisbane in 1945. The company thrived during the post-war boom years through to the 1970s, designing bridges, sewage systems, dams and roads throughout Queensland.
After listing on the ASX in 2004, Cardno expanded across Australia and internationally. A buoyant mining sector and 44 acquisitions saw revenue rise from $94m to $1.3bn over the period to 2014. By then it was valued at nearly $1.2bn, up from $35m when it floated.
Then commodity prices slumped. Mining and oil related investment evaporated and there weren’t enough infrastructure projects to pick up the slack. Engineering firms competed fiercely for what work there was and the industry’s profitability crumbled. Cardno’s EBIT margin, a measure of its operating profitability as a percentage of net revenue, fell from around 15% in the boom years to less than 5% now.
This shouldn’t have been a large problem. In a cyclical industry like Cardno’s, wild fluctuations in profitability are to be expected. But Cardno was carrying a lot of debt. In June 2015, gross debt stood at $400m (net debt was $320m), while the business had less than $700m in net tangible assets.
With lenders increasingly likely to ask for their money back and mounting evidence that Cardno had overpaid for many of its acquisitions, investors dumped the stock. Cardno’s market capitalisation fell to $250m in June 2016.
After raising $170m in new equity and selling three businesses for $150m, Cardno now has one of the strongest balance sheets in the industry with an estimated net cash position of $10m.
Crescent Capital, a private equity firm which owns nearly 50% of the company’s shares, has appointed a new management team which can now focus on improving the business’s performance.
Oil, Trump and Crescent to Drive the Recovery
Cardno operates mainly in Australia and the United States of America.
The Australian business generated $347m in revenue or approximately 45% of the Group’s total in the 2016 financial year. Despite suffering from a fall in mining activity, operating profits fell only 10% to $37m thanks to the business’s strong competitive position within the environmental and engineering industries in Australia. This part of the business should be able to at least match this result over the coming years.
In stark contrast, the American business, which accounts for nearly all the remaining fee revenue, is struggling. In the 2016 financial year, the business earned fee revenue of US$337m, down 20% from 2015, and posted an operating loss of around US$4m.
The large fall in oil and gas prices was only one of the reasons for this poor performance. In fact, government spending, which is usually countercyclical to private investment, was put on hold in the US due to the 2016 federal elections. And, if this wasn’t enough, Cardno’s complex organisational structure prevented its US managers from reacting to the change in market conditions.
The recent decision of OPEC to restrict oil production should help the oil prices edge higher. At the same time, many infrastructure projects should be rolled out over the coming years under new-president Donald Trump. And Crescent has given more power to front line managers by simplifying the company’s organisational structure.
An increase in fee revenue to US$400m and a margin of 8%, well below the historical 10%, would see the division earn US$32m in operating earnings. Importantly, this requires an improvement in the utilisation rate of the current workforce rather than additional investment.
Assuming corporate costs are $10m and the AUD/USD exchange rate remains around current levels, Cardno should earn an operating profit of around $70m within two years. Given the current enterprise value of $440m, Cardno is trading on a multiple of just over six times this estimate. This is low for a good business with a strong balance sheet that should resume paying dividends soon.
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