Hirequip's shrinking margins

By Shoeshine

Friday 3rd September 2004

Graeme Wong's Hirequip has been one of the market's greatest success stories over the past couple of years, rising from 50c to $1.24.

The acquisition by Southern Capital, as it was then named, of the Hirequip equipment hire business from GS Private Equity and the McKinlay family was plainly an inspired move, boosted by a healthy dollop of luck as the construction cycle moved into top gear.

Over the longer term the company is well placed to benefit from pent-up demand for infrastructure spending.

Even so, there are signs the share price has run well ahead of the company's performance.

In headline number terms the June-year result certainly looked impressive. Bottom line profit was up 188%, from $5.8 million to $16.6 million.

But those numbers don't really tell you much.

For one thing, for 10 months of the 2003 financial year Southern Capital owned only 50% of the equipment hire business and so reported its contribution to earnings as an associate.

For 2004 the business's earnings have been consolidated.

The latest year's earnings also include six months' contribution from Ready Hire, bought in late December 2003, and a couple of months from Power Hire, bought in May.

And the company paid only $101,000 of tax on pre-tax earnings of $18.2 million.

That's an effective tax rate of 0.55%, a figure even the banks would be proud of.

That was achieved by using tax losses chalked up by Southern Capital. As these totalled $5 million at the 2003 balance date there can't be much if anything left in that kitty, so the company will presumably pay full tax in 2005.

Finally, as First New Zealand Capital points out, margins in the core Hirequip business failed to improve much, or even shrank.

A "like-for-like" comparison, stripping out the effects of the continuing sale of non-core assets, showed operating revenue was up 26% to $64.3 million, and ebitda (earnings before interest, tax, depreciation and amortisation) was up 28% to $19.3 million, so ebitda margin improved only from 29.7% to 30.1%.

At the ebit level the margin declined, from 16.3% to 15.6%.

Why that happened when economic conditions could scarcely have been more favourable isn't entirely clear.

First NZ acknowledged that acquisition costs would have affected margins and that some synergy gains would appear in future results but still pronounced itself disappointed.

Such concerns hardly mean the company's wheels are about to fall off. The broker is forecasting strong growth in operating earnings this year.

But investors should think twice before they chase the share price up any further.

Mainzeal's mysterious margins

Another company whose performance is mysteriously out of step with its macro environment is construction company Mainzeal.

In the half year to June, Mainzeal reported $US116 million ($178 million) of revenue, ebitda of $900,000 and ebitda margin of 0.5%.

After deducting interest and depreciation (it pays no tax), ebit w as around $100,000 and ebit margin an infinitesimal 0.06%.

Fletcher Construction's ebit margin for the same period, by way of comparison, was 6.5%. Its June full year ebitda margin was 14.7%.

The company and its parent, Richina Pacific, have provided various explanations but none seem to fit the facts and some are, frankly, incredible.

In its half-year preliminary report Richina says Mainzeal's result "does not appropriately reflect on its performance due to the timing of projects which should adjust to reflect positively in the anticipated improved second half."

Ah, so it's all a timing thing.

But the ebitda for the first half of the 2003 year was $5 million, including a $3.2 million gain from a building sale. Stripping that out, ebitda margin was only 1.8%.

Full year 2003 ebitda was $US3.9 million, compared (using like-for-like) with $US3.2 million in the first half, so the company didn't make a lot of headway in the second half.

Full year ebitda margin, excluding the one-off, was 1.5%. Full year ebitda margin in 2002 was 2.4%.

In a red-hot construction sector, that looks more like serial underperformance than timing differences.

Speaking to this newspaper last week, Richina group financial controller Reegan Pearce admitted as much, saying Mainzeal's profits had "never been fantastic."

Richina also advised the annual meeting on June 30 that it had just become aware of "a claim in respect of a project completed in 1994." It denied the claim had merit but said it might nonetheless affect the 2004 profit.

Pearce revealed the claim related to leaky buildings and said a provision made in the first half had chopped earnings.

But shareholders will have to wait and see how much money is involved as the provisions boxes in the half-year accounts are empty.

As all Richina's other businesses are in China it recently shifted head office to Singapore to be closer to its operations all sorts of interesting conspiracy theories could be dreamed up about Mainzeal's poor performance and its future.

Richina is setting up operational boards for each of its subsidiaries.

Mainzeal's was appointed in March and is chaired by Jenny Shipley. The other independent is Clive Tilby, a consultant with lengthy construction industry experience.

They are joined by Mainzeal chief executive Neil Ranford, chief financial officer Mark O'Brien and Richina chief executive Richard Yan.

Shoeshine reckons the relationship between the independents and the executives should be highly interesting particularly when it comes to setting performance targets.

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