Ezra – Review and Analysis of FY 2010 Financials and Comments on Proposed Acquisitions

Ezra released their FY 2010 financials on October 22, 2010; and at the same time, there was also an announcement on the acquisition of two companies for a combined US$325 million (US$250 million + US$75 million). The details can be read up on SGXNet, so I will NOT be posting the salient aspects of the proposed acquisition. Although I had divested of Ezra one year ago in October 2009, I am still monitoring its business, financials and fundamentals by way of interest to assess if the divestment at the time was a correct choice, based on objective evidence and my thoughts at the time. That post one year ago can be found here.

While reviewing and analyzing the numbers from the financial statements, I had a distinctive feeling that the Balance Sheet quality had deteriorated significantly from a year ago, and the Income Statement also showed a similar but gradual deterioration. What I found out from my analysis is strictly based on an objective look at the hard numbers for Ezra as at August 31, 2010; and all conclusions are my own personal one. At no time at all should any reader construe this information as a recommendation to either buy or sell securities of Ezra Holdings Limited, and I shall NOT be responsible for any losses derived thereafter. Notwithstanding the upbeat press release by Ezra (drafted by Oaktree Advisers), I would like to give my objective view on some of the key numbers and financials from an analytical standpoint. Comments are encouraged and welcome in order for me to learn and grow as an investor.

At the same time, I also provide my comments on the proposed corporate financing deal which Ezra had proposed for Aker Marine Contractors (“Aker”) and AMC. I explain why the deal may not be as lucrative as reported in the glossy press releases and presentation slides, and present my view on the potential long-term effects of such an acquisition on the financial health of the Company. The usual disclaimers apply with regards to my comments here, as well.

Comments on FY 2010 Financial Statements

1) Gross Margins are shrinking – Gross margins for FY 2009 were 30.7%, while gross margins for FY 2010 fell to 29.4%. However, this does not show up the fact that gross margins had fallen across two out of three of Ezra’s business segments, as illustrated under section 8 of the financial statement release. Offshore support services’ gross margin fell from 38% to 35%, while deepwater subsea services’ gross margin fell significantly from 13% to a mere 3%. Fortunately for Ezra, deepwater subsea only took up 6% of FY 2010’s revenue, as compared to 14% for FY 2009; otherwise the impact to overall gross margins would have been more striking. Realistically speaking, with a gross margin of just 3%, it is unlikely that the division has any net profit to speak of, as I am pretty sure that admin and other expenses relating to the division exceed 3% of revenues.

2) Admin and Finance Expenses are rising faster than revenues – This can be clearly seen as revenues year on year grew just 7% while administrative expenses increased by 54%. As a % of revenues, admin expenses now takes up 14% for FY 2010 versus 9.7% for FY 2009. Assuming more shrinkage in gross margins, this trend is very likely to further corrode net margins. Another aspect worth highlighting is finance expenses, which had risen 387% in 4Q FY 2010 to US$8.2 million from US$1.7 million due to the very significant increase in debt which the Group had taken on (more on this later). This made FY 2010 financial expenses 81% higher than FY 2009, and remember the increase is mainly made up of just the 4Q FY 2010 increase; if we annualize the increase based on 4Q FY 2010 expenses alone, then the full year impact for FY 2011 is likely to be fairly significant. For information, financial expenses made up 4.5% of revenues for FY 2010, and 2.7% for FY 2009.

3) Share of profits from associated companies and joint ventures is either stagnant, or decreasing – A quick glance will show that share of profits from associated companies was flat year on year with a decrease of 4%, while the share of profit from joint venture was down a significant 86% from US$9.4 million to just US$1.3 million. These two items also impact the Income Statement as the combined effects of higher admin and finance expenses, coupled with lower gross margins, all serve to lower net margins significantly. However, note that all this is not readily apparent as tax expenses had, for some reason, fallen by 66% (it is not known if this is one-off); so the net impact is a 9% rise in net profit attributable to shareholders of US$76 million for FY 2010.

4) Trade Receivables keeps rising – One very noticeable aspect of Ezra’s Balance Sheet which represents a red flag are their receivables, which continues to rise unabated over the quarters. A simple comparison is provided below:-

Trade Receivables AmountFY 2009 – US$182.7 million
1Q FY 2010 – US$164.5 million
2Q FY 2010 – US$156.8 million
3Q FY 2010 – US$217.3 million
FY 2010 – US$205.7 million

If we just use a year on year comparison, trade receivables has risen by 12.6%, while revenue has only risen by 7%. This persistent rise in receivables is worrying, and note that receivables make up 58% of FY 2010 revenues.

5) Rise in current liabilities versus current assets – This is a question of asset quality and liquidity (as well as recoverability). The rise in current assets from US$400 million to US$515.7 million was mainly due to the rise in receivables as mentioned, a rise in inventories, and a significant rise in “other current assets”. Other current assets comprise progress payments and prepayments made to equipment suppliers and for vessel mobilization, and as to whether these are recoverable or are to be expensed off is not known (my guess is most likely to be expensed off in future periods). Current liabilities, meanwhile, increased from US$239.3 million to US$366.5 million, and consists mainly of an increase in debt and notes payables, which I shall elaborate on in the next point.

6) Debt is increasing at an alarming rate – When I first divested Ezra back during October 2009, it was before the Group issued its Convertible Bonds, and way before its recent rights issue to raise S$155 million. I shall extract out the debt portions from its Balance Sheet (see below) and do a simple comparison, to show the effects.

As can be observed in the above, the total debt has risen by 111% from US$309 million a year ago, to US$653.7 million as of FY 2010. Debt equity ratio has climbed from 0.6 to 1.1, and this is before taking on additional debt for the acquisitions (to be discussed later). I did a comparison with Ezra’s cash equivalents and found that net debt increased by 216%.

7) No Free Cash Flow Generation – In the press release, it was mentioned that there was positive operating cash inflows of US$50.4 million for FY 2010, against an operating cash outflow of US$26.2 million for FY 2009. However, the important metric which should be considered is Free Cash Flow, which is cash flow from operations minus capital expenditures. If this is computed, then FCF is negative US$244.9 million for FY 2010, and negative US$202.9 million for FY 2009; so FCF actually decreased by 20.7% over a one year period. Looking at it from this point of view, it is readily apparent that there is woefully insufficient cash generated from operations to sustain Ezra’s expansion plans, which is why they are tapping a lot on financing cash flows; using bank loans, convertible bonds and issuing shares.

8) Payment of a dividend – This is totally inexplicable to me, as Ezra had declared a final dividend of 1.5 cents/share due to “strong operating cash flows”. Considering the company is planning a major acquisition as part of its “next lap of growth”, and needs as much cash as it can afford, why is it paying out the cash to shareholders? Instead of retaining cash for expansion, Ezra chooses to issue shares (dilutive) and take on more debt through convertible bonds.

Comments on Proposed Acquisitions

In the presentation slides for the acquisition as well as the press release, much of the story which is being touted is one in which Ezra will be propelled onto the global stage to be “up there” competing with the major players in the global oil and gas subsea industry. While I acknowledge that this is indeed “transformational” for the Group, an astute shareholder or potential investor has to ask whether the terms of the acquisition and the potential financial effects make sense in the long-term, based on facts available at present. Would the costs outweigh the potential benefits, and will the synergies of the deal be enough to offset the poor gross margins which are inherent in the subsea segment? This segment of my analysis shall attempt to answer these questions, and provide some clarity with regards to the proposed financing deal.

1) Payment Consideration with respect to book value of assets – On Page 1 of the proposed acquisitions document (NOT the press release), it is stated that Ezra will acquire 100% of AMC for US$250 million, and 50% of ACAS for US$75 million. A quick check on Page 2 shows that the book value of AMC is only US$49 million, which implies that Ezra is paying a very hefty 5x of book value for AMC. Since ACAS is a SPV, there are no indicative figures given as to its NBV, except to mention that it is going to construct a vessel worth about US$300 million. If I take the example of SIAEC which is trading at 3x+ book value and has a business model which generates very healthy FCF and ROE of >20% on average for 10 years; then why should Ezra pay 5x book value for a subsidiary of a listed company on Oslo Bors? One should question if the purchase price is considered “reasonable” in light of comparison of business models.

2) Economies of scale, synergies and alignment of corporate cultures – The qualitative aspects of the acquisition were not spelt out in detail, and the presentation slides mostly dealt with the “macro” aspects such as the creation of a much stronger company with assets in excess of US$1 billion. However, one must consider if there are economies of scale between Ezra and AMC; how much of the synergies will flow through to the bottom-line (which is, after all, the point of this whole exercise), and whether there is alignment in corporate cultures between both companies. These should be asked of Management and communicated explicitly to shareholders for avoidance of doubt.

3) Boost to gross margin – Ezra is not too clear on how the acquisition will boost gross margins of subsea, which for FY 2010 was reported as being a measly 3%. In an article published in the Business Times on October 23, 2010, Mr. Tay Chin Kwang (Finance Director of Ezra Group) mentions that “obviously, we are not investing to get this kind of margin. Over time, you will see the margin picking up”. Also, in Ezra’s FY 2010 presentation slides, Slide number 5 mentions that “subsea margins to improve with new markets and additional assets and services”. So far, these are all assertions which do not give much assurance to the investor, as no commitment is made on exactly how much gross margins will improve by. If we compare offshore and marine segments, gross margins have always been healthy and hovered at around 35% and 25% respectively. However, gross margins for subsea have traditionally been much lower (13% for FY 2009, 3% for FY 2010), and there has no far been no indication that gross margins can be higher than 13% (which is historical). Slide 16 of the presentation slides (Part 2) for the acquisition clearly show that Ezra’s proforma projected revenue contribution from subsea is expected to grow to 40% of total revenue, up from 6% currently. If gross margins cannot be significantly raised, this could result in Ezra’s overall blended gross margins to suffer in the coming quarters.

4) Improvement in collectability of debts – With the acquisition of AMC, Ezra is supposed to have a larger base of customers (according to the slide), of which a large chunk are global multi-national players with very good track records and operating histories. Will this mean that collection of debts will improve? Thus far, as mentioned, receivables has been increasing at a somewhat alarming rate, considering revenues have not shown proportionate growth.

5) Financing Structure for the Acquisition – The financing deal which Ezra has proposed consists of 3 sections – the first is payment by way of shares to AKSO (the seller, of 72.5 million shares, or 9.2% of current issued share capital), thereby making them a substantial shareholder of Ezra. The price of the shares to be issued is not mentioned, but presumably it is to satisfy the US$150 million portion of the deal, out of US$250 million. Next is the 3-year convertible bond issue of US$50 million (conversion price of S$1.7959 per share), paying a coupon rate of 5% per annum; and finally a US$50 million payment in cash to the sellers. Collectively, this deal will cause dilution in EPS and dividends for existing shareholders by 13.8% (assuming all CB are converted into shares), thereby reducing EPS from US 11.56 cents to US 7.06 cents). Also, debt will increase by a further US$50 million on the Balance Sheet and interest expenses will go up by another US$2.5 million per year. Ezra is paying a very high interest rate of 5% considering global interest rates are at multi-year lows; hence I was puzzled as to why they did not get a bank loan to finance the debt portion of this deal, as even companies like MTQ can get a line of credit from UOB at very attractive interest rates. The final payment of US$50 million is about 26% of the current cash balance for Ezra and will further drain cash from the Balance Sheet; and this is not even taking into account the payment of US$25 million at the second close for the 50% stake in ACAS.

So to summarize, the deal throws up a lot more questions than answers, and there are many aspects which should be scrutinized more closely, such as the payment of such a high premium to book value for AMC, the current low gross margin for the subsea segment; and also the financing deal which will be dilutive to existing shareholders and which will cause Ezra’s Balance Sheet and Income Statement to weaken further.

My advice to shareholders and interested investors (of which I am NOT one) is to go to the EGM convened to approve this deal and ask many questions. And at the upcoming AGM to be held in December 2010, ask all you can about the FY 2010 financials as I have highlighted above. The red flags highlighted are serious and may have significant long-term effects on the Group if not addressed. I shall end my analysis here and will continue to monitor the Group’s financials over the next few quarters.