Mining for Long-Term Returns
Lycopodium (ASX: LYL) is an Australian based engineering and project delivery group which provides a complete range of services for the evaluation, development, implementation and optimization of projects across a broad range of industries, the most notable of which being the mining, infrastructure and manufacturing sectors.
Figure 1: LYL Overview.
Source: LYL Shareholder Report ASX Release, 24/10/2017.
LYL was established in 1992, listed on the ASX in 2004 and today boasts a global presence, with operations spanning Australia, Asia, Africa, and North America. LYL’s initial target market was the junior miners, with a specific focus on EPCM (engineering, procurement, and construction management; designing and managing projects on behalf of clients).
The scope of the LYL service offering has since grown, having developed a reputation for innovation, cost-effectiveness, and quality with small and medium-sized mining companies. As projects met their cost, schedule, and performance targets, LYL’s credibility grew with larger clients, which today includes the likes of Rio Tinto (RIO), Perseus (PRU), First Quantum Minerals (TSE: FM), Endeavour Mining (TSE: EDV) as well as all levels of Government (Local, State, and Federal).
Though LYL operates in an inherently cyclical industry, we believe the business is well placed to benefit from an improving outlook for global growth and the commodity cycle, as well as the significant domestic infrastructure pipeline.
After enduring a tougher period over the past five years, we believe the prospects for LYL continue to improve off the back of consistent execution and a steadily growing pipeline of opportunity. This view is reinforced by the effective upgrade for full-year earnings, which LYL management expects to be approximately $16.5m. If achieved, this will represent earnings growth of 60.0% on FY2017.
This follows a much improved first half result, with margins trending back towards management target ranges. First half profit was up 36.3 per cent to $7.2m, while the net profit margin expanded by 269 basis points to 7.85%.
Equally impressive is the strength of LYL’s balance sheet. There’s a lot to be said for smaller companies with strong, cash-heavy balance sheets. In our view, such a factor is commonly underappreciated amongst investors and provides both downside protection and optionality. LYL certainly fits well within this category, with cash and receivables, net of all liabilities, standing at $50.6m or about 25% of the company’s market capitalization.
“There’s a lot to be said for smaller companies with strong, cash-heavy balance sheets”
The conservatively managed business and strong balance sheet reflects well on a management team that is highly regarded, experienced, and heavily invested. The LYL board and senior management are either founders or long-term employees, and collectively own over 40% of the business.
Since listing on the ASX, cash generation has been sound and although historically lumpy, Operating Cash Flow (OCF) has consistently exceeded profit. In turn, this has facilitated both consistent dividend payments while incrementally building up cash on the balance sheet. We see the improving fortunes of the group translating to a growing stream of fully franked dividends over the coming 12 to 24 months.
On our current forecasts, we believe LYL will deliver about 43 cents per share of fully franked income over the coming 13 months. This comprises the 12c dividend declared recently (LYL went ex-dividend on Thursday the 29th of March) and a FY2019 forecast of 31 cents per share. As such, LYL is trading on a forward yield of about 6.2%, fully franked.
As highlighted below, we believe LYL’s normalized return on equity is likely to trend back towards its 10-year average over the medium term. Though profitability has been historically lumpy, NROE has averaged 34.7% over the past decade (range -0.5% to 55.5%). Adopting 28% & 30% NROE drives respective FY2019 valuations of $6.01 & $6.51.
Though we view LYL as a high-quality business, the business is exposed to several risks investors must be cognizant of. Ultimately, the key drivers of industry-wide trends are capital expenditure in manufacturing, mining and the public sector. If the volume of work in the industry does tighten it is likely we will see some contraction in industry margins as players scramble to fill their order books. With that noted, it is during the tough times that the strong hands squeeze the weak to provide further upside as conditions improve.
Figure 2: LYL NROE, FY2014 – FY2020e.
History suggests that LYL is certainly a strong, albeit smaller, hand with the staying power to maintain its position through a down cycle.
To be more specific, LYL operates in cyclical and competitive markets, with both factors influencing revenue and margins. This in turn reflects exposure to the commodity cycle.
Material weakness in key commodities such as gold, copper, and iron ore would likely adversely impact the volume of project work available to LYL (and its peers).
At the current price ($4.99 at the time of writing), we believe investors are adequately compensated for the risks noted above. On an ex cash basis, and despite a healthy share price rally, LYL still trades on a P/E of less than 9x, a meaningful discount to our valuation and offers investors a forecast yield of more than 6.0%, fully franked. We see this as good value for a high quality yet cyclical business experiencing a moderate operational upswing.
Clime Group owns shares in LYL for and on behalf of various mandates for which it acts as an investment manager.
Adrian Ezquerro, Portfolio Manager, Clime Smaller Companies Fund