MTQ – FY 2011 Financial Results Analysis and Commentary Part 3

Onwards now to Part 3 of my MTQ FY 2011 analysis, which will cover a major transaction by MTQ – that of its 100%-owned subsidiary Blossomvale Investments Pte Ltd purchasing 200 million shares in an Australian-listed (ASX-listed) company called Neptune Marine Services Pty Ltd (“Neptune”) at AUD 5 cents each. This was announced in a March 4, 2011 announcement posted on SGXNet, and costs the Company about S$12.93 million, which forms a significant portion of their cash and bank balances; hence I have classified this as a major transaction and am delving deep into the rationale. From the announcement proper, MTQ mentions that it seeks to participate in Neptune’s business as a significant investor and views Neptune’s capabilities as a “strategic extension of its predominantly workshop based operations in Singapore and Bahrain”. Kuah Boon Wee, CEO of MTQ, will also take a seat on the Board of Directors of Neptune. I will be breaking down this transaction into parts by analyzing and reviewing Neptune as a company, its proposed strategic changes made, and providing a summary of the actions taken to date to signify its commitment towards corporate overhaul and re-structuring.

Neptune – Introduction

Neptune is a company which specializes in providing offshore engineering solutions to the oil and gas, marine and renewable energy industries. It was founded in 2003 and is headquartered in Perth, Western Australia. Neptune has a comprehensive focus on subsea services with operations spanning Australia and the UK.

The Company, however, has been performing poorly thus far. In its 1H FY 2011 financial statements ended December 31, 2010 (it has a June 30 year-end), it recorded revenue of A$70.8 million and gross profit of A$22.1 million (gross margin of 31.2%), but posted a loss attributable to shareholders of A$11.5 million (after adding back one-off impairment charges). The main reason for this was the very high administrative cost base of A$31.4 million and also high finance costs of A$2.9 million. In the Balance Sheet, interest-bearing loans came up to A$50 million while cash was only A$8.7 million; and the Company is in a net current liability position (technically insolvent). Cash flows used in operating activities was A$4.9 million, capex was A$2.5 million and repayment of borrowings came up to A$4.4 million, resulting in a cash drain of A$11 million in total.

In view of the above poor results, which stems from Neptune’s inability to control costs and is also a result of unfocused operations spanning too many countries, an operational and structural review was undertaken (with PriceWaterHouse Coopers assistance) and has resulted in an offering to raise up to A$80.6 million. More details of it are provided in the next section. The CEO was also replaced in late November 2010.

Neptune – Summary of the Re-Structuring Review

As can be seen in table above, Neptune is planning to embark on a “Back to Basics” philosophy to streamline operations and to refocus on their core competencies once again. Apparently, the impression I got when I read through Neptune’s original businesses was that they had strayed too far off their core competence and had “diversified” too extensively. This had resulted in expenses rocketing up while profits were being eaten away as some business units may be languishing due to lack of focus or expertise. Apparently, the PWC review also brought up many aspects of cost reduction which should have been implemented in an expedient manner, instead of letting the problems fester and drag the Company so deeply into the red.

Some of the key initiatives include focusing more on organic growth versus an aggressive M&A path, which had pushed the Company into a heavy debt-laden position. The strategic review also identified businesses which are working and which should be retained and grown, versus those which are bleeding money and need to be divested. Overheads were too high and the previous CEO did not maintain a lean ship, hence cost-cutting was to be effected (more on this later). Owning assets is also a very expensive affair (as can be seen with Ezra and Swiber) and so JV relationships were more practical and would be easier on the cash flows. Most importantly, the Company wanted to de-gear its Balance Sheet and save on crippling finance costs.

Neptune – Rationalization of Regions

As can be seen in the table above, Neptune’s business is split up into four distinct regions, of which Australia remains their main base of operations. For Australia, though this region is profitable, staff head count was reduced in light of high overheads and commercial focus on NEPSYS was revised in Jan 2011. NEPSYS is a unique, class approved technology that produces a permanent surface quality weld in an underwater environment. For more on NEPSYS, check out this link.

USA is not sustainable and hence Neptune will exit from the business there, cutting costs and saving valuable cash in the process. As for Asia and Middle East, control will vest from Australia under a streamlined regional management structure. For Europe, though the business is profitable, further steps have been taken to reduce the cost base and to perform a more detailed review of options available to grow the business there.

Neptune – Rationalization of Businesses and Assets

Other than just rationalizing regional operations and streamlining operational control by region, Neptune has also undertaken to rationalize its business units and assets to see where it can achieve the greatest benefits, and to find areas to further cut costs. For USA diving business, the decision is to exit from this and look for other partnerships for NEPSYS. This does remind me of MTQ’s own subsea robotics business which was divested in 2006 as it was expensive and unprofitable. The fabrication business in Australia was also deemed not a “strategic fit” and there are plans to exit this. However, I was wondering if this division could complement Neptune’s other business units as even companies like Ezra have a fabrication sub-division even as they provide marine support services.

The ROV (Remote-Operating Vehicle) Supporter and Neptune Trident are to be sold off as these assets no longer contribute meaningfully to the business, and hence should be divested. As of this writing, Neptune Trident has already been sold off (announced in April 2011) for A$14.025 million (more on this in the next few sections). While Neptune has made clear their focus for re-positioning NEPSYS, I am still unclear as to how this technology can be harnesses effectively to produce good profits and attract more reputable clients. By saying that NEPSYS has the “potential for future profits”, one may take it to mean that the technology is slated for a revamp or re-positioning. Since there have been no concrete announcements or plans relating to NEPSYS as of this writing, I assume Management is still hard at work at the problem.

As for the ROV business, I am unaware of how it contributes to Neptune’s bottom line (I only took a cursory look at the financials and did not drill too deep), but since it is profitable but has low utilization, there is thus potential for utilization to increase if the business is positioned correctly and marketed properly. A “full strategic review” will be performed and I guess we can look forward to some corporate decisions regarding this business unit in the near term.

Neptune – Proposed Financial Effects of Restructuring

The first line of “offense” (if it can be called that!) as depicted in the above table should result in annual savings of about A$9.5 million (for Phases 1 and 2); and these involve cutting staff strength and reduction of corporate overheads to make the organization more lean and trim (it’s surprising how inefficiently some processes and operations are structured as a Company expands over the years). This represents the first drastic cost cutting (for Phase 1) which was executed successfully in January 2011 and which resulted in cost savings of up to A$8.5 million. Another A$1 million will come from further corporate restructuring which also includes (ahem) cutting out some Managerial-level staff which may be redundant.

Interestingly, the divestment of non-core businesses is expected to save from A$2 million to A$4 million, as these businesses probably soak up expenses which not churning up sufficient cash and profits to justify their continued existence. Another positive from the divestment is that cash is immediately freed up which can be used to pay down debilitating debt, and also for general working capital purposes. It is expected that such divestments will result in a one-time charge (i.e. loss on disposal) which will hit the Income Statement for FY 2011 (and which may drag into part of FY 2012 as well), but this is inevitable and moving forward, the annual cost savings and cash retained will actually benefit the Group in the medium-term.

If we assume that Neptune can really reduce overheads and administrative expenses by A$12 million to A$13 million annually, and that the Company can continue to garner contracts of significant size, then there is a very good chance of them recording an operating and net profit down the road.

Neptune – Fund Raising and Contract Awards

Neptune had suggested raising funds of up to A$84 million, but in the end they managed to hit the minimum level of A$60 million, which will allow them to pay off almost all of their debt, and un-gear their Balance Sheet. The rest of the money will be used for working capital. New shares were offered at A$0.05 per share, with MTQ subscribing for 200 million shares as many of the existing shareholders did not take up their pro-rata share of the offer. A total of 1.2 billion new shares were issued, bringing total issued share capital to 1.648 billion shares. NTA per share post-rights issue will be A$0.043 cents against the issue price of A$0.05.

Meanwhile, contract flow continues to remain strong for Neptune, as can be seen from the Table above. In Nov 2010, A$8 million worth of contracts were secured, while in Jan 2011 A$12 million more were secured. This may not seem much when compared to its half-year revenue of A$70 million, but note that the rationalization will cause revenues to drop, but expenses to drop even more, thus ensuring that the overall result is profitability even while operating on a lower revenue base. High revenues make no sense at all if they are accompanied by growing losses and continual bleeding of cash. Australia still has its huge Gorgon project which requires the services of many O&G companies, of which Neptune is one. Since Management claims that contract flow continues to be strong, I guess shareholders like MTQ should be expecting a decent top-line performance. Hopefully, this can be coupled with a pleasing bottom-line performance as well.

Neptune – Recent Updates

As mentioned above, Neptune Trident vessel has already been sold for A$14.025 million. A loss on disposal of A$7.5 million will be recorded in 2H FY 2011 as the Net Book Value of the vessel is A$21.5 million, but the good news is that this generates cash which can be used to pay down long-term debts. The targeted completion of sale is in May 2011.

In another recent announcement on May 17, 2011, Neptune confirmed that key initiatives had been completed. These include the finalization of annual cost savings of A$9.5 million (as previously explained), ongoing marketing and planned orderly sale of ROV Supporter vessel, as well as the planned sales of the Australian Fabrication and USA Diving businesses. At the same time, a board renewal plan was also put in place to appoint three (3) new non-executive directors to the Board via a succession plan.

As a result of these measures, Neptune managed to achieve unaudited, normalized break-even operating EBIT for quarter ended March 31, 2011, before write-downs and one-off costs. Greater impact can be seen on the bottom line only in FY 2012, as the measures take effect for the full financial year ended June 30, 2012.

Neptune – Conclusion

It would seem, from all the available evidence and presentation materials, that Neptune is a so-called “turnaround” play, where a major restructuring can bring about much-needed changes to push the business back to profitability and growth. Neptune reminds me somewhat of MTQ back in 2000 to 2004 where they also engaged in all sorts of businesses, from Foundry to Subsea Robotics, and incurred losses every year till Kuah Kok Kim streamlined all the business units, divested the unprofitable ones, and retained just Oilfield Engineering and Engine Systems. For MTQ’s case, it took about 4-5 years (and a skilful divestment of RCR Tomlinson back in FY 2007) to build up core competencies and streamline costs. I would expect roughly the same amount of time for Neptune to realign its business divisions and achieve the efficiencies which it targets. So for MTQ, this should qualify as a medium to long-term strategic investment. As to how Kuah Boon Wee is able to contribute to Neptune’s fortunes and how MTQ is able to synergize, I am as yet unclear until there are further announcements by either company.

MTQ – Resignation of CFO and Company Secretary Mr. William Fong

On April 29, 2011, it was announced that Mr. William Fong, as Group CFO and Joint Company Secretary for the past 12 years, will be resigning from MTQ with effect from June 15, 2011. The Board has appointed Mr. Dominic Siu as CFO with effect from May 18, 2011. I was certainly saddened when I read this piece of news as I had been liaising with him for about a year regarding matters relating to MTQ, including AGM and the recent news on Bahrain. I had also met up with him before during the AGM and found him to be helpful, friendly and supportive. I’d like to wish him all the best in his future career and I guess I now have to start liaising with the new CFO, Mr. Dominic Siu!

Conclusion

MTQ will be going through a very interesting phase of its growth, with its Oilfield Engineering Division firing off the new FY 2012 with its operations commencing in Bahrain. Coupled with high oil prices and investments by major O&G players to the deepwater segment, as well as more stringent regulations governing BOP after the BP Deepwater Horizon incident, this should bode well for the Division and ensure its slow and steady growth. For Engine Systems, I am confident that MTQES can continue to build on the momentum of recent acquisitions as well as their partnership with Bosch to further improve margins and increase top-line contribution. Of course, this will all take time and watching the growth of a business through the years is a very satisfying process and validates my commitment to being a value investor who has his eye on the business performance of a Company rather than constantly tracking its share price.

As for Neptune, the detailed analysis and summary which was provided above made me realize that MTQ is in this for the medium-term of at least 3 to 5 years, similar to their previous investment in RCR Tomlinson which was divested in 2007. While it may look like a bad idea in the short-term (with Neptune’s recent share price hovering around AUD 3.6 to 3.9 cents), I am also quietly confident of Mr. Kuah Kok Kim and Mr. Kuah Boon Wee’s business acumen in being able to identify suitable investment opportunities in mis-priced businesses to grow MTQ’s business value over the years.

For future reviews of MTQ, I will also be including a review (both financial and operational) for Neptune. The next review for MTQ should only be out in late October 2011 as they will be releasing their 1H FY 2012 results then. In the meantime, I await the final issue price (yet to be decided) for the final scrip dividend of 2 cents/share; and also await the arrival of FY 2011’s Annual Report.