Friday, 22 November 2013

Trouble at Forge Group

Shareholders of Forge Group (ASX:FGE) must be bracing themselves for the worst when it eventually resumes trading on the ASX, having been in suspension since 4th November due to serious problems with its Diamantina Power Station EPC contract, and its West Angelas Power Station. Pictured below, both contracts were inherited upon the acquisition of CTEC (renamed to Forge Group Power) in January 2012.

Diamantina is the more important of the two with a contract value of $430 million, compared to the West Angelas Power Station at $150 million. This makes Diamantina the second biggest project FGE has undertaken, with the largest being the recently announced $830 million Roy Hill iron ore joint venture. Although management have issued a further four requests to extend the suspension, they have provided few details around what went wrong, why and by how much. What is known is that they expect 'a material diminution in FY14 earnings', are in discussions with ANZ over its banking facilities, and are rushing to prepare a prospectus for a 'low document' accelerated rights issue (ie they need to raise capital desperately).

With a dearth of information, rumours have it that FGE may be forced to raise $50 to $100 million at a price as low as $0.50 or $0.625 per share, compared to its last share price of $4.18. In perhaps a worst case scenario of requiring $100 million at $0.50, FGE would have to issue 200 million shares. With 86.2 million shares currently outstanding, existing shareholders would be diluted more than they dilute the Coke at McDonalds. Whether or not these horrifying rumours are accurate, FGE is certainly in deep trouble and the share price will fall dramatically when it resumes trading.

After thanking my lucky stars that I sold out of FGE in February this year at $6.17, I thought it would be didactic to examine what investors can learn from this debacle. Although the announcement caught just about everyone by surprise, me included, one of the main reasons why I exited FGE was due to some concerns over the significant shift towards the lower margin Forge Group Power subsidiary. In June this year I wroteForge Group (FGE), the first stock I bought in my portfolio, was sold after their half yearly report in February. Forge continued to rack up stellar results with NPAT up 60% compared to the previous half and an even larger cash balance, leading many investors to believe that FGE could really defy gravity. However, I saw differently - if you take a close look at its order book, you'll see that the lower margin 'power' subsidiary is now far more important to future work than its traditional mining services business, which had struggled to secure new contracts. Hence, despite the appearance of a stable order book, I believe the slowdown had indeed hit FGE months ago and earnings will consequently decline if the power division is the main revenue driver. It seems Clough (another mining services business ASX:CLO), who held 36% of the company, see something similar coming as they sold their entire holding in March at a price just under me. 

It appears that Forge Group Power has indeed become the main revenue driver, with revenue from this segment growing 86% to $495 million in FY13, representing 47% of total revenue. While it might sound like I did pick up on the issues at Forge Group Power, I want to stress again that I absolutely did not anticipate large problems at the Diamantina and West Angelas power stations. What I did predict was declining margins and when you get into lower margin work, risks increase since a relatively small increase in costs can wipe out all the expected profit. Exacerbating this risk is the fact that FGE has significant leverage, not in the traditional sense with debt, but through its order book. Standing at $1.8 billion, FGE's order book is many times larger than its equity of $213.4 million. Large contracts such as the $430 million Diamantina Power Station have the potential to wipe out equity if something goes pear shaped, particularly when margins are small. In addition, sizeable contracts place a strain on the balance sheet of mining services companies as they require lots of new working capital and bank guarantees or insurance bonds. These guarantees to clients are essential for FGE if it wants to continue winning new contracts, but this also requires FGE to maintain a strong balance sheet. This fact likely washed over many investors who saw an excellent looking balance sheet with net cash of $78.3 million in FY13, despite the fact that this cash buffer was necessary to obtain those bank guarantees and insurance bonds. Subsequent to year end, the $US43 million Taggart Global acquisition would have also weakened this figure, leaving FGE in a more vulnerable position.

With perfect hindsight, I can also point out some red flags with management. The founding directors held a substantial amount of shares and did a great job in managing the company up until they commenced a transition plan in March 2011 where they eventually exited to make way for new management. After leaving FGE, they sold all of their shares. As I mentioned before, Clough also sold their 36% stake at $6.05 in March this year to institutional investors, who must be quite livid right now (although they may be getting their chance to exact revenge by pushing for a very low price in this upcoming rights issue). It may just be a coincidence, but it's a bad look when the people who know FGE intimately are selling everything. It's an even worse look when the new management don't buy either - the directors currently hold a laughable 11,000 shares in total.

Further rubbing salt in the wound for current shareholders is the rather generous remuneration. David Simpson, the managing director appointed in July 2012, was handed a $750,000 sign on fee, a base salary of $1 million, and a $500,000 bonus in FY13 for increasing earnings per share by more than 10%. However, it is the 'ex-gratia' bonus (translation: the remuneration committee is feeling extra generous) of $300,000 that must really sting given the serious questions that must be now asked of his management of the business. Was it another coincidence that no mention of the problems at Diamantina and West Angelas were made until after FY13 and the Annual General Meeting when all the bonuses had been paid? Speaking of bonuses, take a look at this from the FY13 annual report:

Shareholders were already very unhappy with the remuneration, as they voted 15,504,648 against the adoption of the remuneration report at the AGM, versus 22,709,503 for. This is over the 25% limit for a first-strike, and it looks like a good bet to assume that shareholders will vote with even more fury next year after learning of the Forge Group Power issues. Heads have already started to roll, with chief operating officer Brett Smith leaving FGE and Forge Group Power's managing director Kevin Robinson departing a few weeks earlier. I also note an interesting find by the Australian Financial Review, almost certainly referring to David Craig: Furious shareholders in a once-popular mining services company perhaps shouldn't be too surprised at the recent turn of events which has seen the group suspended from trading, pending a likely profit downgrade. By our calculations, the chairman has been involved at board level of no less than four other listed companies since 2010 where the shares have fallen by 90 per cent during his tenure. Which by our calculations means they only have another 80 per cent to fall. While I may have painted the current management in quite a negative light, I would like to remind readers that they inherited these troublesome contracts from the CTEC acquisition made by the previous management. Nevertheless, management has either been dishonest or incompetent in managing these contracts, perhaps both. I'm sure IMF (Australia), a litigation funding business I hold, would be looking closely at this for a potential class action lawsuit. 

A couple of other potential warning signs would have been the weak operating cash flow in FY13 of $17.9 million compared to net profit after tax of $62.9 million, and the vague explanation for 'inventories and construction work in progress' increasing from $11.3 million in FY12 to $150.5 million in FY13. While I've outlined a few aspects that may have pointed towards trouble for FGE and are useful to keep an eye out for in other investments, in the end I think that this announcement is really something that could not have been predicted. These are the risks you take when investing in businesses - and it reinforces the importance of having an adequate amount of diversification if events like this send you into a nervous breakdown. I feel for the shareholders who've been unfortunate enough to hold FGE at this time, especially considering the scarcity of information provided to them since the November 4th trading halt. 

Does the inevitable drop present a buying opportunity? That's much too early to say, although I would advise prospective buyers to be careful. As previously mentioned, the bank guarantee and insurance bond facilities will be hard to come by with a weaker balance sheet. Without adequate working capital and these facilities, the $830 million Roy Hill contract may not go ahead. While this contract may provide a big boost to revenue, it is another large risk due to its size - I've also heard the Roy Hill contracts have been competitively bid and subject to onerous conditions. FGE may also suffer a hit to their reputation as to their ability to successfully complete projects for clients, which will make acquiring work in the tough mining services space even more challenging. A goodwill write-down could be imminent since FGE picked up $23.6 million of goodwill from the CTEC acquisition, and this could affect banking covenants. There is also the cockroach theory to be mindful of - there may be more than just two bad contracts hiding underneath. Finally, there is the issue of whether one can trust management anymore, and whether a big shakeup might cause significant disruption to FGE at a critical time. It will be very interesting to see how this story plays out...


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