Contrarian investing sounds good on paper. Buy deeply out-of-favour stocks, do the opposite to the investment “crowd”, or as Baron Rothschild said, “Buy when there is blood on the streets”. However, trying to understand the “crowd” and predict market sentiment is fraught with danger
A better approach is to value businesses, think like an owner, and ignore market noise. Do not fall for the greatest bear trap of them all: letting price alone determine whether a stock is cheap. It is only cheap if the price is below the company’s intrinsic value; not because it has fallen sharply on a chart, or because investors have anchored their expectations on a previous price: usually the 52-week high.
Consider the troubled transport and logistics provider McAleese Group. Several fund managers, who probably should have known better, paid $1.47 for its shares in a November 2013 float that raised $166.2 million. Six months later, McAleese has slumped to 44 cents.
It has had two significant revenue and earnings downgrades in a matter of months, and on some metrics may be getting close to breaching its banking convenants. Risks are high.
Contrarians who search for stocks that have been irrationally sold – or dumped during bouts of panic – will closely watch McAleese. Nothing has gone right for it since listing. Even the company’s sponsoring IPO brokers, who normally gush about “house stocks”, went cold on McAleese, a few months after its listing.
Before its latest earnings downgrade, a few broking firms had 12-month price targets for McAleese around 90 cents a share. Some brokers downgraded their recommendations this week to ‘undeperform’, and slashed their forecasts.
McAleese has a long list of problems. Net debt to equity is high – perhaps uncomfortably so if earnings are not stabilised.
Macquarie Equities Research this week wrote: “We now estimate McAleese will have $251.5 million in net debt by June 2014 and estimate the net debt /EBITDA ratio will be 2.7 times in both FY14 and FY15. McAleese has a covenant to keep this ratio below 2.75 times. We estimate McAleese will be more comfortable on its gearing and interest cover covenants.”
Also, McAleese has a short listed history, only a handful of analysts cover the stock, and the company’s sustainable competitive advantage is hard to identify.
Transport is a tough industry at the best of times. Trucking companies require high upfront and ongoing capital investment, idle trucks quickly depreciate when demand wanes, and contracts can be lumpy and easily terminated when work slows.
Short term, McAleese is subject to the vagaries of gold and iron ore prices through its resource transport operation. Rail projects potentially reducing demand for trucking services in some ore projects are a medium-term threat.
Then there are McAleese’s recent problems. To recap, a Cootes tanker crashed and exploded on a Sydney street last October, killing two people. Cootes is a wholly owned McAleese subsdiary. The crash triggered a national safety audit that later saw 79 Cootes trucks taken off New South Wales and Victorian roads for repairs. It shocked the market.
Other press reports in December referred to a suspected gas leak on a Cootes Transport LPG tanker, and a second incident involving a suspected gas leak. The safety concerns were so serious that Cootes grounded its fleet and had third-party inspections during last October and November.
Cootes was front-page news and featured on the ABC’s Four Corners. Politicians fumed that defective Cootes trucks hauled dangerous materials through densely populated capital cities. The business media hinted McAleese could face a shareholder class action for a potential breach of its continuous disclosure obligations. In a worst-case scenario, McAleese could break its banking covenants or require a heavily discounted equity capital raising, much to the chagrin of current shareholders, according to market speculation.
Amid the safety concerns, McAleese lost the national Shell and the BP (NSW) contracts in its oil and gas operations, and withdrew from a 7-Eleven contract (NSW and Queensland). The unanticipated revenue loss and increased repair and maintenance costs after the Sydney accident crushed its earnings outlook.
Adding to McAleese’s “perfect storm” was unseasonal weather affecting demand for its West Australia operations, and expected weaker demand in its Specialist Transport and Lifting division.
As a result, McAleese revised its expected FY14 underlying earnings (EBITDA) to $107.5 million, compared with $126.8 million in the prospectus. Downgrading prospectus forecasts within months of listing is cardinal sin for any IPO, let alone those that slash them by 15 per cent.
To further dismay the market, McAleese downgraded its earnings again this week. It said third-quarter revenue was $9 million behind February forecasts and $7 million behind the EBITDA forecast.
The fallout has been felt in management: CEO Paul Garaty and Chief Financial Officer Chris Nunn left; McAleese’s major shareholder, Mark Rowsthorn, was appointed CEO; respected transport veteran Don Telford became chairman.
Cootes faces a complex, costly exercise to restructure its business, repair and upgrade the fleet, and reduce its average age. Restoring confidence among key clients – and the market – will prove just as challenging, given McAleese’s reputational damage.
The problems raise questions about McAleese’s business model. Its strongest selling point in the IPO was a focused transportation business that could grow quickly through acquisitions.
We could go on with the long list of challenges facing McAleese. The key question is whether McAleese’s market price has fallen too far, and if it provides a sufficient margin of safety to buy, given the risk of further earnings and valuation downgrades.
There is some good news. The return of Rowsthorn as CEO should help in the medium term, although this week’s guidance downgrade has battered already fragile market confidence in McAleese. Senior management changes are never a good sign, especially so soon after listing. But the entrepreneurial founder is usually the best person – sometimes the only person – to steady the ship during a crisis, and protect their wealth tied up in the company.
The recent renewal of the Norton gold haulage contract for four years – worth about $65 million in total revenue – was a boost, given it is an important part of McAleese’s Kalgoorlie business. News in March that Cootes Transport could continue to operate in NSW was further good news.
Although it looks cheap, McAleese could stay that way for some time – and might be best avoided. This is one ‘falling knife’ that contrarians are better off watching and waiting until the point of maximum pessimism in McAleese has passed – and its becomes clear that the company’s bank convenants can be maintained.
Also, it is hard to find a catalyst for an earnings recovery, given commodity prices are likelier to fall than rise in the next year, potentially lowering production volumes at some mines and reducing transport demand. The general slowdown in resources capital expenditure is another headwind for McAleese given its significant exposure to mining and energy transportation.
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at April 16, 2014.
Click on the links below to read other articles from this week’s newsletter