MTQ – FY 2010 Analysis and Commentary Part 3

We have come to Part 3 of my MTQ analysis, and I hope the previous 2 sections have been useful thus far in reviewing the company. I was hoping to get some constructive criticisms but thus far there have been no comments given on either Part 1 or Part 2; so now I am pressing on with Part 3 which is much more qualitative in nature.

Part 3 will discuss the prospects of each division (i.e. Oilfield Engineering and Engine Systems), as well as comment on the prospects and likely business climate for each division and for the Company as a whole in the next 6 months (till MTQ release their 1H FY 2011 results). I will also touch briefly on MTQ’s capital structure in the near-term and their likely cash flow and dividend stream.

Oilfield Engineering Division

Oilfield Engineering has always been the mainstay of MTQ’s business, as my analysis of purchase had described, they are one of the few played in the region which can provide timely and quality service to customers, thereby resulting in repeat business with a loyal customer base. Looking at the results for FY 2010 though, one can see the damage done by the global financial crisis on this division, as oil majors had drastically decreased their spending on E&P amid tight financing conditions; and also because most of these majors have become cautious on spending too much in case they were unable to sufficiently recoup their investments. Note too that oil prices had collapsed from a high of about US$148 per barrel to the current US$70 per barrel, and there could be further weakness moving forward due to the current Euro crisis. MTQ are, to a certain extent, exposed to this risk as they are servicing clients in the South-East Asian region where the players are more sensitive to oil prices. However, there may be light at the end of the tunnel in terms of managing the volatility of the revenue stream for this division (see next para).

In Jan 2009, MTQ announced that they were venturing into Bahrain, a country in the Middle East, and were planning to build a new facility there up to 3 times the size of their Singapore Pandan Loop operations. Since then, they had awarded a contract to build Phase I of the development to a contractor, and work has since begun and is targeted to be completed by early 2011. Assuming the facility starts to attract customers and generates revenues, the revenue stream would be far more stable as the oil majors in the Middle East region are not so affected by fluctuating oil prices; rather their cost of production is probably just US$1 to US$2 per barrel! MTQ would also be able to capture a new base of customers there (barring strong competition from incumbent players, of course) and perhaps also extend their existing business relationships with their current pool of customers to service their Middle Eastern operations. Of course, at this juncture there is still no clarity on business prospects and potential revenues as the facility is under construction; but if assuming all goes well, this new facility could significantly boost MTQ’s business in the long-term.
Another thing to note about this division is its high barriers to entry (in terms of service quality and services offered) and thus it can garner sufficiently high margins of up to 24%. Assuming the Bahrain workshop can command the same premium pricing, and barring fierce price wars initiated by competitors, MTQ should be able to maintain their margins for this division. However, I would expect contributions to only flow in from 2H FY 2012 earliest.

Engine Systems Division

A quick recap on this division – Engine Systems had shown surprising resilience during the downturn and turned in a respective set of results. Part of the reason for this may be attributed to the Bosch Superstore concept which was part of the deal which MTQ signed with Bosch (starts Nov 1, 2009). Therefore, if we extrapolate the positive effects on the division’s business, revenues and margins, I can safely conclude the FY 2011 would be a year of growth, or in the worst case scenario, revenues would remain flat (if compared year-on-year as FY 2010 only had 5 months where Bosch Superstores were operating). The margin improvement to 3.2% was a pleasant surprise and as the legacy units are being divested within MTQES, net margins could rise further; this coupled with synergies from cross-selling Bosch and MTQES’ own automotive parts and diesel engine systems may mean better economies of scale, with minimal additional capital expenditure. Of course, this is assuming that the Euro crisis and subsequent fallout does not have a sharp negative impact on MTQES’ business and throw a spanner in their engine (mind the pun).

With the acquisition of Premier Fuel announced back in March 2010, MTQES has now expanded their Australian coverage to include 10 outlets (inclusive of the one in Northern Territory occupied by Premier). At this point, it is unsure if the Company will channel more of their funds into the Bahrain construction or if they plan to reserve some to acquire more companies to boost MTQES’ capabilities and reach. I can only speculate that Management seems to be want to take a pro-active approach to improve MTQES’ margins and also their competitive capabilities, and this is a good sign as it implies they do not let a business division languish just because it has lower margins and revenues than a more profitable division. A Company must act as a holistic entity and manage its resources well; and thus far this has been demonstrated by Management as they astutely avoided debt and generated good cash flows.

The upcoming AGM would be a good opportunity for me to question Management on their intentions for MTQES, and whether there are plans to grow it further. I shall also wait for the Annual Report commentary by the Chairman to see if there is any MD&A on MTQES; and also browse through the operations review. The AGM should be held sometime in July 2010.

Changes in Capital Structure

MTQ had announced their Bahrain expansion plans and for now, Phase I will make use of internal cash flows and cash reserves to fund. This would also include paying for costs and staff salaries to recruit suitably qualified personnel and train them to appropriately deliver quality service which is in line with the service levels at its Singapore branch. All these activities will mean that substantial expenses will need to be incurred, and it may be quite a while before we can observe the positive effects of such spending on productivity and quality which would translate into revenues, earnings and cash flows.

However, per Management, Phase I will not involve a dramatic change in MTQ’s capital structure as the upfront cost is only about US$9.6 million. Phase II, which will probably commence work in early 2011, will involve much more (though no exact figures were given); and so MTQ will most likely have to fund this phase of expansion through the use of bank financing (i.e. bank loans). With current gearing being very negligible, this increase in bank loans will result in more financing costs and the net cash position which the company enjoys now may also be threatened, depending on how well they can generate operating cash inflows into the future.

On a positive note, in the current low interest rate environment, it may be better for MTQ to take up some financing (paying low rates), and deploy their cash reserves to better effect to maximize returns for shareholders. I believe this is what the Chairman, Mr. Kuah, intends to do in order to conserve cash resources, as he is confident the bank will lend them the money as MTQ has a strong balance sheet and healthy cash flows. Assuming Management knows how to deploy the cash to enhance returns, I would think this is a good strategy to adopt.

Cash Flows and Dividends

That said, cash flows and dividends may take a temporary hit due to the above-mentioned events taking place; and as MTQ uses more cash to fund its new facility and also to expand MTQES’ networks. For FY 2010, MTQ managed to sustain its dividend payment at 1c/share interim and 2c/share final; but for FY 2011 I highly doubt the company can maintain this payout unless operational cash flows turn out to be much stronger than anticipated. Although Mr. Kuah sounded an optimistic note in his interview with NextInsight that dividends at current levels can be sustained, I have a tendency to be more pragmatic (call it “pessimistic” if you wish) and assume the worst – that the Company will have to drop it dividend or in the worst-case scenario, stop paying dividends altogether if the macro-economic environment continues to deteriorate. Although this is an unlikely possibility, it still must be considered as I am currently enjoying a decent yield of 4.37% on my investment in MTQ (based on 3c/share full-year dividend).

Conclusion

I remain cautiously optimistic about the company’s prospects and Management’s capability to grow the business, though I am also mindful of the potential slowdown should the global economy be hit by another “whammy” delivered by the European debt crisis. As to whether I should add to my position or simply to sit and monitor, I am also contemplating my next course of action. Above all, I must strive to maintain a margin of safety on my purchase and to enjoy a decent yield. Capital preservation remains the cornerstone of my investment philosophy.

My next review of MTQ will be after the release of 1H FY 2011 results sometime in late October 2010, or if there are any material corporate developments along the way.