Outotec - Time To Start Buying A Quality Company In A Cyclical Industry

Aug.19.14 | About: Outotec OYJ (OUKPF)

Summary

Outotec is a company with 23% average ROE over the past 7 years and annual growth rates of 10% and 12% in sales and book value, respectively.

The company operates a cyclical business which is currently facing headwinds, implying the opportunity to begin purchases.

Downside should be small for investors willing to average-down (should the price go lower) as the company’s balance sheet is strong and valuation currently not optimistic.

NOTE: All USD figures were converted from euros at EUR/USD 1.34.

Outotec [(OTC:OUKPF), (OTCPK:OUKPY)] is a Finnish industrial company with a tech aspect to it: "Outotec provides leading technologies and services for the sustainable use of Earth's natural resources. As the global leader in minerals and metals processing technology, Outotec has developed many breakthrough technologies over the decades." (Company fact sheet) The company's two business segments are Minerals Processing (42% of sales in fiscal 2013) and Metals, Energy & Water (58%). Service sales are an important part of Outotec's future as they provide some stability to the cyclical business and most likely better profit margins as well. In fiscal 2013 service sales represented €505.9 million ($677.9 million) or 26.5% of total sales. The company's target is to reach service sales of €1 billion ($1.34 billion) by the end of 2017. Currently, the target seems unattainable within the next 4 years as it'd mean annual growth of 18.5% in service sales. Also, the EBIT target of 10% over time is at the moment a distant hope.

Other financials look decent for fiscal 2013. Sales were €1911 million ($2560 million), gross margin was 20.7% and operating profit 7.4%. Return on equity of 19.3% is the first sign of a quality business, although 7 year average is slightly higher at 23.5%. Return on invested capital was 13% in fiscal 2013 with a 7 year average of 16%. Book value in the same period has grown 12% annually, from €214.7 million ($287.7 million) in 2007 to €477.4 million ($639.7 million) in fiscal 2013. Using the numbers from 2013 the company looks very attractive. With the current market cap of €1270 million ($1702 million), one can buy Outotec for 10.5 times EBT, 6.9 times EBITDA (net cash of €33 million/$44 million) and 2.85 times book value. A company that has grown revenues from €1000 million ($1340 million) in 2007 to €1911 million ($2560 million) in 2013 (annual growth of 10%) is certainly an interesting buying opportunity when offered at these valuations. (Company key figures)

Those numbers give a rosy picture of the situation in the most recent past. During the first two quarters of 2014, Outotec hasn't done that well. The company reported an operating loss in Q2, first quarterly operating loss in years. Sales came down in the first half by 33% year-over-year, profits took an even bigger dive. On top of this, they had to lower the guidance for the rest of the year. The current guidance expects sales of €1400 to €1600 million ($1876 to $2144 million) and a 4% to 6% EBIT from business operations for fiscal 2014. According to management the lower bound represents a pessimistic scenario and the upper bound an optimistic scenario. These struggles haven't been unnoticed by the market resulting in a sliding stock price. Partly the results are a sum of several negative matters happening approximately at the same time, including timing of orders and cost overruns with some larger orders.

During the past 5 years, Outotec has made large investments in the future. Net working capital has increased by €121 million/$162 million (12% of incremental sales in the same period) while investments in growth capex have equaled roughly €39 million/$52 million (4%), acquisitions €135 million/$181 million (13%) and R&D €173 million/$232 million (17%). In other words the company has relied more on organic growth. Because the business is asset-light in nature (net PPE currently €82 million/$110 million) growth capex is not the place where Outotec can really make big investments in. Regarding the acquisitions, most of them have been relatively small compared to the size of Outotec and mostly targeted towards companies that possess some expertise or technology that Outotec sees complementary to its existing technology. Shareholders have also received their part as the company has returned €225 million ($302 million) in the past 5 years via dividends and share buybacks.

Outotec has funded the above investments and returns to shareholders via several routes. Firstly, the company's net cash has decreased (net debt increased) by €181 million ($243 million) in the 5 year period (currently net cash is still €33 million/$44 million). The other major source of funds has been internal cash flow. The company's reported cash flow is very lumpy because of changes in working capital. Taking the operating cash flow excluding changes in working capital gives a better picture of what the business has been able to produce. During the same 5 year period, this number comes to €324 million ($434 million). With ROICs averaging 10.5% for the period (2009, 2010 and 2011 showed ROICs under 10%) the company's investments have paid off quite decently, even though one sure hopes that the next 5 years come closer to 20% than 10%.

Cases

Outotec has stated that it targets 10% to 20% growth in revenues. Assuming the company hits the lower bound of the 2014 guidance, €1400 million ($1876 million), they would need to grow 10% annually for 6 years to reach €2500 million ($3350 million) in 2020. Maybe a somewhat bullish expectation but not really out of this world considering the low starting point. Assuming the company will reach its 10% EBIT target, it'd make €250 million ($335 million) in operating profit. A fair EV/EBIT multiple for a quality company like Outotec would probably be around 10 (some could argue it to be higher), which would give an EV of €2500 million ($3350 million), double the current EV.

In the Q1 conference call, CEO Korhonen stated that the industry is seeing some positive signs and that the industry analysts are forecasting a growing industry CAPEX for 2015-2016. For this forecast to materialize, it should show as growing orders right now. The same line was repeated in Q2 conference call where management initiated that there are positive signs but that in the end it depends largely on timing. Whether orders reach Outotec in some quarter or the next is always uncertain. These uncertainties in timing are also partly responsible for the lumpiness of order intake. And as the CEO commented, they're currently starting to see the order intake growing, and now the hope is that this will sustain. Another promising factor for the future is the fact that the company is continuously looking at its process efficiency and other matters in order to cut costs where sensible. What this will do is enable the 10% EBIT target to be reached before the peak sales.

In a pessimistic scenario, one assumes the growth from €1400 million ($1876 million) in fiscal 2014 will be a mere 5%, resulting in €1875 million ($2513 million) in sales in 2020. Using the average EBIT margin from the past 7 years we get €150 million ($201 million) in operating profit. It's up for discussion what a fair multiple in such a situation would, taking for example 9.5 would put the enterprise value at €1425 million ($1910 million), up 15% from the current value.

Finding the very bottom isn't an exact science either. In late 2008 when the financial crisis hit, Outotec's market cap was in the lowest point about €400 million ($536 million). In fiscal 2008 book value was €226 million ($303 million), implying that the stock was trading at roughly 2 times book value. Taking this as a proxy and assuming the company's book value slides to €400 million ($536 million) would result in a market cap of €800 million ($1072 million), down 37% from the current one. The author wouldn't bet that we will see this kind of prices. If we do, then it should be a juicy spot for both long -and short-term investors to pile up the stock.

In the short-term, next year or two, it's anyone's guess what happens. Analysts aren't on average waiting for miracles in the next years, although the variation in fiscal 2016 estimates are wide (sales estimates between €1751 million and €1219 million/$2346 and $1633 million). There has been and could certainly continue to be weakness in the share price. It's worth noting though that Outotec, being a cyclical company, should be bought when the times get tough and investor sentiment turns toward hopelessness. Whether we're currently swimming in the bottom or not is impossible to predict.

Risks

No doubt that operational risks are the biggest ones with Outotec. With the current (small) net cash position, the company most likely won't be facing any big issues with its debt (debt to equity currently at 0.53), even though it's not unlikely to see the company going into a net debt position in the near future, first time in years. Valuation-wise there doesn't seem to be a massive risk. Surely the multiples can come down from what they currently are, but this would be the result of deteriorating operational results. This also works the opposite way, if and when the cycle turns better and operational results find higher grounds, multiples can easily expand from what they currently are.

Outotec's operational results are more or less dependent on how the mining sector is doing and how much it is investing. What the mining sector's next years look like is something the author wishes not to speculate with, as it is more certain that the guess would be wrong instead of right. For now, it should be enough to realize that the stock's performance will be highly related to the operational performance of Outotec and that the operations of the company most likely aren't in a terminal decline. This is another way of saying that when the price is low, buy, and when the price is high, sell. Can the operational results go even lower? For sure they can, but whether or not there'll be more negative surprises remains an open question.

Outotec doesn't disclose the revenues from individual countries but from the Q2 report we can see that EMEA's, including Russia, share of order intake in H1 dropped to 33% from 57% year-over-year. This strongly signals the fact that the geopolitical risks of Russia are impacting Outotec. This should be perhaps viewed in a more positive way though, as Outotec has a successful and long history in Russia. Shortly, this implies that when the political situation finally stabilizes at some point in the future, the company will receive very meaningful orders that were delayed because of the political situation that is holding investments back (although Outotec's customers aren't the 'black list' companies they're still affected for example by the difficulty of getting financing for their investments).

Catalysts

The most significant catalyst in the eventual rise in the value of the company is simply the eventually improving operational result. The management is lined up to take the challenge. They state three simple priorities for the rest of 2014 as 1) winning new orders, 2) growing the service business (the €1000 million/$1340 million in service revenue is still in place, although management has said it might not be exactly 2017) and 3) improving profitability. Showing signs of improving EBIT margin and sales are the primary things to follow just as they are the primary things the management focuses on. For investors though, it's most likely too late to start thinking about beginning share purchases when the reports are already showing clear signs of a better future.

Although not the biggest catalyst but as has been discussed, Outotec has been hit by the issues in Russia and therefore will benefit when the situation clears out and companies begin to ramp up the investments that they've been increasingly holding back as 2014 has gone forward.

For short-term investors, there might be a catalyst coming again in the form of rumors about M&A. In July the rumors of Weir Group (OTC:WEIGF) making an offer to buy Outotec were spread. The stock price of Outotec immediately shot up about 15%, after which it has come back down when the rumor was shot down by Outotec's management (and after bad Q2 results). If an offer does come the stock price will jump up. Even the rumors of an offer could also be viewed as a signal of the potential Outotec has in the long-term when purchased at these price levels.

Roadmap for investors

For long-term investors, the case is relatively clear. Buy when the market is gloomy and sell when everything seems rosy. That's certainly easier to say than do, but the current price of Outotec does offer a very decent spot to begin purchases. As there's the possibility of the price dipping lower, one would be well-served by doing incremental purchases along the way. Starting the purchases from the current market cap of €1270 million ($1702 million) and keeping it as the upper limit while continuing purchases along every 5-10% dip, should those occur, might prove to be a prudent way to deal with Outotec. This way the investor should expect to get +10% returns in the long-term and higher if purchases at even lower prices could be made. And to those asking the question whether investors would be better off by simply waiting for the bottom prices the answer is yes. Investors with the crystal ball are encouraged to take advantage of it. For the rest of us, the author recommends making incremental purchases should the price come down. The current price serves very well as a starting point for purchases.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in OUKPF over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author doesn’t currently hold a position in the company but intends to establish a position in the next 30 days. Please, do your own due diligence, there’s always a risk of losing one’s principal.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.