One of the Australian Shares Fund’s most recent investments in the mining services industry is GR Engineering (GNG). While GR shares many clients with some of the Fund’s other mining services businesses, it doesn’t share many of their pitfalls. What makes GR one of the better mining services businesses?
Specialising in designing and building mineral processing plants for a fixed price, GR has been able to carve out an attractive niche for itself within the highly competitive engineering sector. Most of its clients are junior miners that happily outsource these risky projects to a specialist. Even if that means paying a bit more.
Drawing on decades of experience, GR has been able to consistently avoid cost overruns and time delays.
And, so far, it hasn’t had to deal with any few contract disputes, mediation, arbitration or litigation. And, so far, it has only been required to deal with a few contract disputes, mediation, arbitration or litigation. Thanks to this excellent track record, the company often wins additional work from old clients to carry out plant modifications, upgrades and expansions at a later date. The only major competitor in Australia is Sedgman, now part of CIMIC. Market shares vary year by year depending on contract wins, but generally the two companies have a 25% share each. While Sedgman dominates the coal segment, GR dominates the gold segment.
As the accompanying table shows, revenue can swing wildly depending on the state of the mining sector and large contract awards. Since listing in 2011, annual revenue has ranged between $110 million and $217m. But despite this inherent volatility the business has proved resilient. Profits have averaged $18m per annum and have been increasing since bottoming in 2013 at $10m, despite a weak mining environment. Importantly, contrary to the other mining services businesses in the portfolio, GR doesn’t require much capital to grow. Since 2011 GR has spent only $6m in capital expenditure and paid out $77m, nearly all of its profits, as dividends.
More often than not it’s the industry structure that best explains shareholder returns in the long term. But in GR’s industry good management is paramount. Bidding for work at a fixed price is not for everyone. As Forge Group’s collapse showed, a couple of bad contracts could be enough to bring the whole business down. On this front GR is well served. Management has decades of experience in managing such projects and an impressive history of creating value for shareholders.
Instead of diversifying the business across many sectors, GR’s management has been focusing only on building processing plants for miners. Over and over. This specialisation forms the backbone of the company’s competitive advantage as it allows it to price contracts accurately. Management, though, has still been able to reduce the business risk profile.
Over time GR has expanded its service offering to include a large number of different commodities. This ensures that GR can continue to win work even if the state of a particular commodity market deteriorates. Also, in 2014 GR acquired Upstream Production Solutions. This business is run separately from the core engineering business and mainly provides operational, maintenance, and well-management services to the oil and gas sector in Australia and South East Asia. GR bought this business opportunistically from a large corporation that needed to sell it quickly. Upstream Production Solutions had $5m of net working capital at the time, was generating about $30m in revenue and $2m in profit before tax. The purchase price of $6m was a steal.
Currently there is an estimated $1.5 billion worth of projects being tendered to the market. GR has completed 30 consulting jobs in 2016 and is currently working on another 15. This has historically been an accurate leading indicator for subsequent contract awards. We expect GR to win its fair share of work, especially in the gold segment, where it has historically been the leading player. GR’s mineral business should be able to generate around $200m in revenue and earn $20m in operating profit this financial year. The following year should be another good one. Beyond that it’s hard to say.
The oil and gas business, Upstream Production Solutions, should be more predictable. Over the next three years this business should generate at least $65m in revenue per annum based on current work in hand. While margins are lower than those of the mineral business, Upstream should generate operating profits of more than $5m per year over this period.
GR currently has a market capitalisation of $240m and $65m in net cash. Its price to earnings ratio and dividend yield are 13 and 6% respectively. Despite the stock price nearly doubling since the Fund’s purchase, these valuation metrics are not demanding for a well-run business that should grow over the coming years. Directors and senior managers own more than 50% of the company. So we expect that they will continue to run it prudently and allocate capital sensibly. Despite this, and the strong balance sheet, bidding fixed pricec remains a risky business and so position sizing is critical. Currently 4.5% of the Fund is invested in GR and we think that this is appropriate.
This blog post is an extract from our September quarterly report which will be released in the coming days. Email adm[email protected] if you would like to be added to the distribution list.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.