This week has been a bad one for just about everyone involved with Forge Group, which has officially gone into voluntary administration. 'Sad' and 'mad' are probably a couple more words that employees, shareholders, creditors and counterparties would use to describe how they feel about this extraordinary turn of events. Even though I don't belong to any of those groups, it's depressing to be reminded of how ruinous things can get when companies fail.
In my last post on Forge, when it was in the middle of its 24 day long trading halt, I speculated on what might happen, and already started to draw some lessons to be learned. Eventually, management spilled the beans, and it wasn't pretty: they would incur a $127 million profit downgrade on the two troubled power contracts, with a net cash outlay of $45 million required to complete them. It seems to me like management didn't have any good reasons for the downgrade - they just completely stuffed up in managing these contracts. Instead of raising money at around the rumoured $0.50 or $0.625 per share level, ANZ came to the rescue by waiving debt covenants, increasing Forge's working capital facility from $11 million to $60 million, and deferring principal repayments. The string attached to the deal was that ANZ would receive 11.2 million warrants (equivalent to 13% of the shares on issue), exercisable at a comical $0.01 each. Essentially, shareholder dilution was far less than expected, but the increase in debt raised the risk profile of an already weakened business.
Shares started trading again on 28th November, opening at $0.38, dropping to a low of $0.285, rising back up to a high of $0.865, and then settling down to close at $0.685. That's what the price range for a normal stock looks like over a year or two, never mind a single day! From the $4.18 prior to the trading halt, $1000 invested in Forge would have plummeted to just $68 at the low, and $164 at the end of the day, which is one of the sharpest declines I've personally witnessed. Here's what the one year chart looks like.
At that point in time, I think a sensible argument could have been put forth for a very high risk, high reward punt on Forge. If it were to survive and in a few years recover even to a fraction of where it was before, an investor might make 3x or 4x their money, while the most they could lose would be 1x their money if Forge went bankrupt. Were you to apply a 50% probability to each scenario, the mathematical expectancy would compel you to invest. Despite the seductive logic of the numbers and the attractiveness of contrarian bets to value investors such as myself, I decided against an investment (again I thank my lucky stars with Forge), as the situation was just too risky for my liking.
Securing $40 million in asset management works in North America, reaffirming the $830 million Roy Hill contract was still on track to go ahead, and BlackRock Group (the world's largest asset manager) buying up shares, all served to push the share price to a high of $1.96 on 30th December. There was some serious volatility on this day, opening at $1.10, rising to an intraday high of $1.96 and closing at $1.585. The newfound optimism was cut short with a trading halt on 10th January, followed by the announcement of a further $23 to $28 million writedown on the troubled West Angelas Power Station project.
Ten days after coming back onto the market, Forge went back into another trading halt. Again, the news wasn't pleasant: instead of the $45 to $50 million pro-forma EBITDA guidance for FY14 given after the first trading halt, it would now be a loss of $20 to $25 million. In other words, the underlying business was expected to lose money. This downgrade was attributed to two more contracts becoming unprofitable, tougher market conditions, and the necessity of managing the business for short-term cash flow. In a sign of the dire situation, management arranged for a shareholder meeting on 4th March to renew their capacity to issue up to 15% of the shares outstanding without prior shareholder approval. Various third parties were disclosed to have taken an interest in acquiring Forge, but in the end all of them walked away.
Thirteen days later, and Forge is in another trading halt, but this time it isn't coming out. The financiers withdrew support for the company on 11th February, with the inevitable result of administrators being appointed. Forge must have been bleeding so much cash that ANZ had to put an end to the business. Indeed, according to the Australian Financial Review, debts had built up to a staggering $500 million, with creditors such as ANZ and insurance bondholders expected to lose money. With their estimated $200 million exposure and now worthless warrants, ANZ are no doubt kicking themselves for replacing NAB as Forge's main lender in mid-2013. Of the 1753 staff in Australia, more than 1400 employees were retrenched, and it will be difficult for them to find jobs in a weak mining services sector. On the plus side, the sale of Forge's assets, and the Federal Government's scheme will ensure they receive their basic entitlements, while some of them may be able to find work with new contractors. The international businesses in South Africa, Asia and the US will operate as usual until a buyer can be found, so the 814 overseas employees might have a bit more luck. Shareholders are very unlikely to be receiving anything, perhaps a sincere apology from management is all they can hope for.
Even after going through all these developments, I'm still dazed at how this came to be. If you take a cursory look at Forge's last annual report for FY13, you see a very decent set of financials for a mining services business: return on average equity of 33%, a current ratio of 1.4, $90.7 million in cash, another $10.5 million in term deposits and debt of just $25.7 million (ie. net cash of $75.5 million compared to equity of $213.4 million). One lesson to be learned is that a perfunctory glance at a few numbers or ratios will not cut it - as I outlined last time, there were some warning signs in the financials, and if investors understood how Forge made its money, they would see a much larger degree of leverage. Nevertheless, if someone told me Forge would have $500 million in debt within seven months and had gone into administration I probably would've laughed.
This business had a very fast rise, with net profit rising from $2.7 million in 2007 to $62.9 million in 2013, but an even faster decline. It reminds me of the pendulum that Howard Marks speaks about in his book, The Most Important Thing, where he tells investors to keep in mind that almost everything moves in cycles and that eventually the pendulum will swing the opposite direction. For a time, the mining services sector was doing quite swimmingly, helping businesses like Forge to produce excellent results, and luring investors into thinking that the mining boom was the new norm. Most people forgot about the cyclicality altogether, but now we have an unpleasant reminder of its distorting effects and that investment adage: what the wise man does in the beginning, the fool does in the end.
Maybe another lesson to be learned is the role that luck plays in investing. While you could sit here all day and try to scrutinise every piece of evidence with perfect hindsight, I think the biggest factor here was just bad luck. It all started with the problems at the two power contracts, which without inside information, would have been impossible to foresee. This kind of blow up could have happened at many other mining services companies, but Forge shareholders had the misfortune of being in the wrong place at the wrong time.
My best wishes go out to all those affected by Forge Group's collapse.