Bought Boom

Today I purchased 7428 shares in Boom Logistics (ASX:BOL) at a price of $0.175 each. For those of you who have never heard of this business, it provides crane and lifting solutions to customers in the resources, energy, utilities and infrastructure segments. I had briefly taken a look at this company a few years back and passed, but it was brought to my attention again by a good friend of mine, Alex, who posted about Boom on his excellent blog The 8th Wonder.

After conducting my own research, I reached similar conclusions to Alex about the business, eventually deciding to stop sucking my thumb and to just pay a little extra for some shares. Since I don't think I can put forth the case for investment any better than he already has (and because I'm admittedly a little lazy right now), I recommend you go read his thoughts here and here. Alternatively, he's given me permission to simply copy and paste those posts right here for your convenience. Enjoy!

23 Cents on the Dollar

Boom Logistics (ASX:BOL), Australia’s largest crane and lifting solutions provider, caught my eye recently with its price trading at nearly one fifth of tangible book value. After further inspection and a phone call with management, I took a position at $0.12.



Times have certainly been tough of late for anything marred with the mining service brush, and it has been no different for Boom. While this is not a high quality business by any stretch of the imagination, it seems that the market is currently pricing Boom as if death is imminent. When the herd is avoiding a sector like the plague, this has the potential to create opportunities for the contrarians among us.



Boom’s derives the majority of its revenue through maintenance contracts with Australia's major mining companies (as well as energy, infrastructure and civil construction work) which bodes well as Australia shifts from a mining ‘capex’ cycle to one of operation and maintenance. An improvement in residential construction that is underway, along with the increasing trend of crane intensive high density buildings, is also a positive as it may help to soak up crane supply and boost utilisation across sectors. 



While Boom’s profit history has been disappointing due to asset write-downs and restructuring charges, its consistency of operating cash flow is attractive. Over the last 5 years, Boom has averaged $50m of operating cash flow per annum, almost as much as its current market cap. Management have guided they expect capex to be less than depreciation ($20m expected), which coupled with the $11m of asset sales, bodes well for free cash flow (FCF) in the vicinity of $30-40m for FY14. This places Boom on a FCF multiple of less than 2 times!



What is certain is that a stock is unlikely to remain at 2 x FCF or 0.2 of book for long, either free cash flow or book value will reduce or the price will rise. As I expect FCF to be resilient, this gives management optionality in terms of capital management.



Management are aggressively repaying debt (with $12m repaid in the first quarter and a full year target debt balance of $90m) and have stated the intention to buy back stock on market to capitalise on the discount. Boom’ s net debt to equity is currently 33% and is likely to reduce below 30%, which is less than half that of peers such as Ausdrill and Emeco who trade on similar discounts.



The currency sensitivity is also interesting. Boom invested $140m over the last 3 years when the AUD was close to or above parity with the USD. As cranes are sourced from international suppliers, Boom was able to take advantage of the strong currency and replenish its fleet at relatively good prices. However, with the AUD at $0.90 and with expectations that it will continue to fall, cranes are not getting any cheaper in Australia. This bodes well for Boom’s crane values and reduces the probability of future write-downs. However, given the size of the discount at which the price trades at, shareholders have a significant buffer even if write downs do materialise.



There are a number of catalysts which have the potential to provide a rerating: an on market buyback, continued debt reduction announcements, a return to bottom line profitability and a takeover offer from private equity or a trade buyer. Given that sentiment is so bad towards the sector, even a slight normalisation has the ability to provide a rerating.



As Boom trades at such a large discount to NTA, an acquisition creates interesting accounting implications for a potential acquirer. For analysis sake, let’s assume McAleese (ASX:MCS) (who has a large presence in the QLD lifting market and who also has been a substantial shareholder of Boom in the past) is successful at acquiring Boom at $0.20 per share. This represents a ~50% takeover premium for current shareholders. However, as Boom has NTA of $0.51, MCS is likely to record a profit on acquisition of $0.31 per BOL share, as they have acquired $240m of equity for only $94m. No doubt a large profit created by sound capital management would give MCS’s management a tick of approval from their new shareholders. Given its discount, operating cashflow history, relatively lowly geared balance sheet and open register, it seems plausible for Boom to attract some takeover attention.



To me, the epitome of an investment (protection of principal whilst also providing a sound probability of an adequate return) is often found in stocks that have very low expectations incorporated into the share price. If bad news eventuates, the downside is less severe as many were already expecting bad news. However, if good news eventuates, the price is way too low and must quickly rally, thus providing the return. It is these asymmetric opportunities that I love to fill my portfolio with.



Boom is certainly not a buy and hold forever stock idea, nor should one be expecting the price to revert to book value in the near term. My view is that buying at a P/B of 0.20 and waiting for one of the aforementioned catalysts provides a reasonable probability of selling at 0.40 of book (the medium term average) in the next 3 years. If it takes all three, that gives 26% annually. Any sooner is a bonus!

Half Yearly Result Update 

Boom Logistics reported its half year results last week which were on par with my expectations . However, with $319m of equity that is currently generating poor returns, management have some decisions to make.



First, let's revisit the thesis. My attraction was based around the ability to buy lots of tangible assets cheaply, and as the group’s cranes were under employed, disposals and reduced capex were two likely drivers of significant free cash flow. Steve Johnson from Intelligent Investor said it best, 'these businesses have been cash sinks as they grow, they should spew out cash as they shrink'. While it is still early days, it seems management are beginning to gain some traction and the wheels are turning in the right direction. 



Operating cash flow for the half came in at $11m, which was a little below par. It seems clients have been stretching out payments as Booms receivables only decreased 5% while sales fell 23%. Asset sales of $8m were achieved which contributed to $13m of free cash flow, with the majority directed to reduce the debt balance to $102m on a net basis. Importantly, there was no asset impairments and NTA increased to $0.52 per share. To refinance its banking facilities, management were required to conduct a thorough assessment of its assets and to come through without an impairment certainly adds confidence. I will be eagerly watching the full year result for an improvement in operating cash flow and further debt reduction.



I caught up with CEO Brendan Mitchell last week and we discussed an interesting opportunity for further assets sales. There is currently $65m of assets which lay under utilised with the majority idle due to the BMA contract loss. While it seems the preference is to get them re-employed into another contract, management will consider selling the entire fleet if this doesn't occur in the reasonably near term. While conditions remain tough and there is plenty of surplus equipment for sale in the market, prices for cranes haven't plummeted as far as Booms share price would lead you to believe. Indeed, $1.6m of assets were sold for a profit in January. Here lies the opportunity. $65m is nearly 90% of Booms current market cap, however for the sake of conservatism, if we assume a 50% haircut, management could still repay a further $10m of debt and buy back $22m (30%) of stock. This would most certainly reduce balance sheet risk and create immense value for ongoing shareholders.



It seems odd, but I think missing out on further contract wins could work out to be better for shareholders. And if Boom does win work, its not a negative either, creating somewhat of a win-win situation.

Farewell Forge

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. 

Sold Blue Sky Alternative Investments

In June last year, I described the rationale behind putting 16% of my portfolio into Blue Sky Alternative Investments (BLA) at $1.25 per share. Today, I'm quite pleased to report that I have sold out at $2.15, making this stock a 70%+ gain in just over seven months. It is true that this span of time is insufficient to determine whether my thesis about the business was ultimately sound, but I'm not going to complain about making a quick buck. 

Initially, I made the case that if assets under management (AUM) could reach $1 billion in four years' time, BLA might reasonably be valued at a market capitalisation of $132 million (three times higher than the then market cap of $40.6 million). Since then, AUM has grown from around $250-$300 million to $400 million at the latest count, which is well on its way to management's target of $500 million by the end of FY14. While this is good progress, I've been less happy about the two capital raisings conducted since I purchased BLA. 

There is something suspicious about raising $6.8 million from institutional investors at $1.40 per share and then going back less than four months later for another $25.6 million at $1.50. The stated rationale was to invest the proceeds in BLA's own managed funds, which is supposed to further demonstrate to potential clients that BLA has confidence in its own investment performance and therefore drive increased AUM. This may make some sense, but why the need for two capital raisings in such a short space of time? Then one needs to weigh up the dilutive impact of issuing new shares. In this case, BLA has raised significant amounts of money, which has resulted in the number of shares on issue rising from 32.5 million to 56 million currently, and therefore the market capitalisation has leaped up from $40.6 million to $123.3 million - almost the value that I had in four years' time!

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Consequently, the primary reason for selling out is due to a dramatically reduced margin of safety, which makes me uncomfortable to hold. Even if BLA manages to achieve a more than twofold increase in AUM to $1 billion over the next four years, the returns to future shareholders are unlikely to be commensurate with that increase anymore - as share prices rise, the returns of the future are brought forward into the present. Of course, it is quite possible that BLA will live up to the ambitious $2 billion in four years that management has cited, but banking on that level of growth to justify an investment at the current share price appears a bit too optimistic for me. I'm changing my forecast from blue skies to cloudy. 

This sale brings my level of cash to almost 28% of my portfolio, so it's back to the drawing board for new stock ideas. Fortunately, there are a few companies that I'm interested in, but it is quite possible none of them will find their way into my portfolio. The last time I felt I had too much cash, I went out and bought DSB, which has turned out to be a regrettable decision, so I'll do my best to exercise more patience this time around. At least it seems the Oracle of Omaha shares my weakness: I make my mistakes when I have a lot of cash around. 

Three Years On

Today marks three years to the day that I first purchased a stock under a value investing rationale. Since then I have learned a great deal about the challenges of investing, and also earned a chunk of money along the way. Of course, the journey of learning has only begun, but if it continues to be this enjoyable then I'll be sticking around for a while.

As I said the first time I posted my performance on this blog, I believe that for a value investor, the absolute minimum period of time upon which you can start to judge ability is three years, although a five-year test would be far preferable. The shorter the timeframe, the more that good or bad luck comes into the equation, but give an investor a few decades, and skill almost entirely accounts for the result. Please keep in mind that for the first 15 months, I only held one stock (Forge Group), so one could argue that period of time shouldn't count. With that said, judgement day has arrived, and I'm not all too worried.

In dollar terms, the biggest winner has been Forge Group, with a net $1124 gain (including brokerage and franking credits). Conversely, Delta SBD has been the major drag, as I currently sit on an $809 paper loss. All up, my portfolio started out with $5522 and is now at $8465, which is 53.3% gain. This works out to a compound annual growth rate of 15.3%. If I can maintain that trajectory, I'll cross the million-dollar level in around 33.5 years, and if I manage to hang on until age 100, my birthday present that year will be the attainment of a billion dollar nest egg. While these are obviously simple extrapolations, they make the point that just about anyone who saves a small amount of money and patiently invests it sensibly (either personally or through a fund manager) can end up quite wealthy.

These are satisfactory absolute results, but they need to be viewed in the context of the general market, which I have chosen to be the All Ordinaries Total Return Index. During the same period, the index has appreciated by 25.9%, or an annual rate of 8.0%. This happens to be slightly below the historical long term return of circa 9%-10% annually, so this hasn't been a particularly buoyant period. It is interesting to note that the Small Ordinaries Index Total Return Index - comprised of the smaller companies more representative of where I invest - has declined by 15.3% in the past three years, but I'm not about to go changing my benchmark to look better. The number I deem to be the most important is an investor's annualised outperformance/underperformance relative to the index, and I have previously stated my goal is to beat the All Ordinaries total return index by at least 5% per annum over the long term. So far this has been achieved at 7.3% annualised outperformance.

Although I think most people would view my set of numbers as quite good, and despite the arresting mathematics of compound interest highlighted above, I have occasionally felt that my performance hasn't been good enough. When you see or hear other investors producing extraordinary results in a short space of time, it is easy to want to change strategy and start betting on more speculative situations that offer the possibility of great gains, but also great losses. At times like these, I like to remind myself of one of my favourite Charlie Munger quotes: Someone will always be getting richer faster than you. This is not a tragedy. And then once again, I am content with being the billionaire centenarian.

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Margin of Safety by Seth Klarman

During my two-week cruise to New Zealand (in which I surprisingly didn’t see a single sheep), I was delighted to find time to finish off Benjamin Graham’s seminal value investing treatise, The Intelligent Investor (fourth revised edition) and Seth Klarman’s 1991 book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. I thought I’d briefly share some of my thoughts on the latter. 

Although he is now deemed to be one of the legendary value investors, Klarman hasn’t always been so popular. His first and only book so far, Margin of Safety was a commercial failure and has since gone out-of-print after an original run of 5,000 copies. However, as Klarman continued to produce superb results at The Baupost Group, the hedge fund he co-founded in 1982, people soon started searching for the secrets to his success. The laws of supply and demand have thus caused the price of his elusive work to skyrocket - on Amazon, a used copy will currently set you back at least $2,000 while new copies start from $3,800. You would be hard pressed to find this book in a library as most copies have been stolen. So Mr Klarman, I hope you’ll forgive me for opting to download a digital copy of your book.

Seth Klarman is no doubt an excellent value investor, but if I am honest, I didn’t find Margin of Safety to be an exceptional read. It seems unclear who his target audience is: most beginners will get lost as Klarman generally assumes prior knowledge of concepts and jargon such as discounting cash flows, while at a relatively paltry 250 pages or so, more advanced investors will probably find little to dig their teeth into. There really isn’t anything that you cannot find somewhere else. And unlike writers such as Peter Lynch, there is no humorous, conversational tone to be found within these pages. Having said all that, I still found Margin of Safety to be well worth my time as it was thought provoking to consider the nuances of Klarman’s approach, and it’s always interesting to read about case studies. Moreover, I was pleased that a few chapters in the final third of the book resemble the ‘special situation’ investing that Joel Greenblatt brilliantly describes in his title You Can Be a Stock Market Genius. Klarman gives readers a taste of the opportunities available in corporate liquidations, ‘complex securities’, rights offerings, risk arbitrage, spinoffs, thrift conversions, and financially distressed/bankrupt securities. In being able and willing to take advantage of these more obscure investments, I think this is where Klarman really shines as an investor, and it is an area that I would like to better understand. 

While all value investors share the common foundation of trying to purchase undervalued securities, there is considerable variation in the exact implementation of this approach. Although he often cites Warren Buffett, Klarman is more of a cautious Benjamin Graham style investor than a modern day Buffett as he gravitates towards tangible asset plays and discloses his wariness for the value of intangible assets. In fact, his values (if you’ll excuse the pun) are so similar to Graham that he had the honour of being the lead editor and a commentator on the sixth edition of Benjamin Graham’s Security Analysis. Klarman has notched up circa 20% annual returns since inception of Baupost Group, taking it from assets of $30 million in 1982 to $29.4 billion in 2012, and remarkably done so whilst often holding high levels of cash, another indication of his conservative style. On the debatable subject of how to value businesses, Margin of Safety outlines three different valuation techniques that he finds useful: net present value (discounting cash flows), liquidation value (what would be left for investors if the company were dismantled and the assets sold), and ‘stock market value’ (looking at prices on equity and debt markets to approximate value in some situations). He also mentions ‘private-market value’, which is where investors look at what kind of multiples that sophisticated, prudent businesspeople have recently paid to acquire similar businesses, however, he cautions that these multiples are not necessarily rational and prefers that investors determine what they themselves would pay instead. 

Unfortunately, like many parts his book, by cramming the important subject of valuation in just one chapter, Klarman doesn’t provide as much discussion or as many examples as I would have liked. For instance, he is extremely vague in describing what rate to discount cash flows at, other than saying that there is no single correct discount rate, and that it should be influenced by an investor’s preference for future dollars, the risk of the investment, and interest rates. Readers have no way of determining whether 5%, 10% or even 50% is appropriate, other than a sole case study where he applies a 12% and 15% rate without justification as to how he arrived at those numbers. Reflecting the indeterminate nature of discount rates, Klarman explains that it is impossible to come up with a precise value for a stock, but this is unnecessary if investors buy at a significant discount to a range of values obtained through one or more of the above valuation techniques. This is the crucial value investing principle of the margin of safety first proposed by Benjamin Graham, which Klarman has aptly used as the title of his book. 

Throughout Margin of Safety, Klarman advocates targeting absolute-performance and decries relative-performance, going so far as to declare ‘value investing is absolute-performance-, not relative-performance oriented’. Although I can see the logic in pursuing absolute returns, I have to disagree with Klarman here. If you decide to actively select investments in the share market, it makes sense to be measuring yourself against the ‘average return’ easily obtainable by buying into an index fund. An annual return of 5% over the long term may seem satisfactory to absolute oriented investors, but if everyone else is achieving 10%, I would argue that you have done a poor job and wasted your time, value investor or not. Buffett shares this view: ‘Relative results are what concern us: Over time, bad relative numbers will produce unsatisfactory absolute results.’ And speaking of index returns, Klarman also says, ‘I believe that indexing will turn out to be just another Wall Street fad’, calling it ‘both lazy and shortsighted’. Well he has certainly been proven wrong in the 22 years since he wrote that, and for good reason - endless studies show that over time, the vast majority of investment professionals underperform the broad market indices after fees are accounted for, and therefore an ordinary person is almost guaranteed to beat them by simply purchasing a low cost index fund. Once again, Buffett has the good sense to agree with me here. 

Despite the nitpicking, I have much respect for Klarman and can suggest his book to intermediate or experienced investors as a decent rundown of the value investing approach if they are in need of some investment reading. I’ll be adding both Margin of Safety and The Intelligent Investor to my recommended reading page, and I leave you with a selection of quotes from Margin of Safety that were interesting or insightful to me. 

“To some extent value, like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone.”

“Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning.”

“Information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.”

“Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.”

“Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid. In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.”

“Investors must recognise that while over the long run investing is generally a positive-sum activity, on a day-to-day basis most transactions have zero-sum consequences. If a buyer receives a bargain, it is because the seller sold for too low a price.”

“In times of general market stability the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion. During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep.”

“Investing, it should be clear by now, is a full-time job. Given the vast amount of information available for review and analysis and the complexity of the investment task, a part-time or sporadic effort by an individual investor has little chance of achieving long-term success.”

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 wrote: Forge 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...

Google Trends

As any investor with a casual knowledge of the ASX would know, internet stocks such as Carsales.com (CRZ), Seek (SEK) and REA Group (REA) have been great stocks to own. If you owned REA for the last 10 years, you would have had a total shareholder return of 55.2% per annum according to Commsec, or in other words, a dollar invested in 2003 would be worth 81 dollars today. These phenomenal results are largely due to the network effect: buyers want to go to the website with most amount of X being sold, and sellers want to be on the site with the most buyers, thus creating a self reinforcing cycle for the most popular website. It seems that because of the power of the network effect, these kinds of markets gravitate towards being a monopoly or duopoly over time, the end result being that the winner takes all.

For these internet based stocks, getting pageviews is crucial to riding the network effect, and it is my hypothesis that since a major source of traffic comes from Google, having access to Google's information should provide a good indication of the general trend in website traffic, and therefore, provides clues to the future performance of the business. However, it must be noted that there are other important factors that influence whether views will translate into revenue such as the amount of time each visitor stays on the website, and that many of these businesses such as Carsales branching into different domain names in foreign countries so they are not solely reliant on their flagship domain anymore. In addition, mobile apps are increasingly playing a larger role in driving consumer traffic, so perhaps the importance of Google to these business is declining. With those disclaimers aside, I thought it would be an interesting exercise to compare some of the changes in website interest through Google Trends, with some more in depth information from Alexa.

According to Alexa, 23.8% of the traffic going to Carsales.com.au comes from Google, and of this, the top keywords searched for were 'carsales', 'car sales', and 'carsales.com.au'. It is ranked the 53rd most popular website in Australia and visitors spend an average of 9 minutes and 52 seconds on the site. The two largest competitors to Carsales in Australia are Trading Post (which also sells caravans and boats, amongst other things) and Carsguide. To keep things simple, I've limited the keywords to 'carsales', 'carsguide' and 'trading post'.

As the above graph clearly shows, Carsales has experienced a huge increase in interest since 2004, which is reflected in its business fundamentals, while Trading Post has suffered a continuing decline starting from around 2009. Poor old Carsguide is a very distant third place. Further compounding the woes of Carsguide and Trading Post is the fact that visitors only spend 3 minutes, 28 seconds and 3 minutes, 40 seconds respectively on each website, which would significantly reduce the number of sales produced for each visit compared to Carsales. However it seems that even interest in Carsales has plateaued and started to decline - I wonder whether this waning interest will see their domestic revenue growth start to diminish, or maybe it suggests a broader slowdown in the car industry.

Taking a look at the job market, Seek is the dominant player in the space and the 26th most popular website in Australia. 24.1% of traffic originates from Google, and visitors average 8 minutes, 8 seconds on the site. The rise and dominance of Seek when viewed against its competitors looks quite similar to Carsales:

Again, Google search interest in Seek hasn't increased since the start of 2011, but unlike Carsales, Seek is facing the threat of LinkedIn which is gaining traction in Australia. Although LinkedIn is a social network more focused on people in professional occupations, the size of this global business and the more social approach has got the Seek CEO, Andrew Bassat, quite wary. Even with the competitive advantage of the network effect, leaders such as Seek can't afford to become complacent lest they end up with the same fate as the newspapers (who've failed to gain a foothold with Fairfax Media Limited's MyCareer and News Limited's CareerOne joint venture with US company Monster).

While I can't find a breakdown of revenues for the carsales.com.au branch of Carsales, Seek is nice enough to show 'look through' revenue for each of its segments. The Seek domestic revenue from FY2011 to FY2013 provides confirming evidence for the link between flat Google search interest and flat revenues.

The usefulness of tools such as Google Trends and Alexa don't just apply to these kinds of online businesses. In this day and age, driving visitors to your website is an important goal for most companies, and investors can gain insights as to what is gaining popularity and what is not, long before it is reflected in any financial statements or recognised by the market. I recall reading about an American who noticed that a particular Hollywood film was very popular, and after researching the production company behind it, concluded that the financial benefit from the movie would be very significant compared to the small size of the company. He made a ton of money out of it when the market eventually realised this, and has continued to do the same in similar situations when he recognises a growing trend that others have yet to discover. One could gather similar insights through Google Trends about movies, toys, restaurants etc. Or, you can just play around with it out of interest - contrary to popular belief, dogs are actually searched more than cats!