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AECI faces substantial headwinds

Company’s failure to diversify comes back to haunt it.

AECI is facing substantial headwinds and its failure to meaningfully diversify operations has become its biggest pitfall. So while it screens well on value, we maintain our previous hold recommendation because its is likely to remain under pressure in the short term.

The company’s acquisitive drive is a step in the right direction. It is targeting companies in the agriculture (Farmers Organisation Malawi), water solutions (Clariant Southern Africa) and food & beverage (Southern Canned Products) sectors. However, it is still heavily exposed to the mining and manufacturing industries. About 56% of its revenue comes from mining solutions.

Indications are that conditions in the global and local economic environments will remain difficult in the short to medium term. Commodity prices, particularly those to which AECI is exposed (coal, platinum, iron and copper), are likely to remain weak because of reduced demand from China. Cost pressures in the mining industry are precipitating contract reviews or retendering. A number of miners are restructuring, shelving new capital investments or scaling down operations. AECI is going to be pinched by such developments.

That said, we still think AECI shares are good fit for patient, long-term investors. The company is well positioned to perform if market conditions improve. Its fundamental metrics are solid. Despite some big acquisitions over the past two years its balance sheet is strong with low gearing of 13%. This gives management room to unlock more value by increasing leverage. Its investment case is also supported by an impeccable cash-generation capacity, earnings consistency and an undemanding price:earnings ratio. With a dividend yield of 4.1%, AECI also suits income-seeking investors.

While lack of diversification might be an issue for now, we doubt it will be in the medium to long term. Management’s strategic drive to expand its presence in water solutions and agrochemicals is likely to lead to a more diversified business structure in the long run.

AECI’s results for the year to end-December were boosted by bulk property sales, the contribution from acquisitions and a recovery in the platinum sector, which suffered a five-month strike in the comparable year. The weaker rand and higher sales volumes in explosives (albeit at lower margins) and specialty chemicals also contributed. Revenue climbed 9%, but the operating margin fell to 9.2%. Headline earnings per share grew 6%, aided by the property sales which contributed 230c/share to the reported figure of 894c/share. The board took advantage of the windfall from the land sales and declared a total dividend of 385c/share, 13% higher than the previous year.

Prospects

Key to our valuation assumptions for AECI is our short-term view on the mining industry – the division’s key market. We feel that the group’s exposure to the sector is going to be a drag on its performance as conditions are likely to remain difficult, despite recent signs of recovery in some mining segments. Commodity prices are still under pressure and some mines are expected to close if there is no meaningful recovery. Others are undertaking operational restructuring with a strong focus on cost containment in their supply chain. This will compromise AECI’s ability to grow earnings. Management says that while it retained the majority of its South African business in the retendering processes, it had to sacrifice margins.

Nevertheless, we think good performances from the businesses exposed to water solutions, agriculture and the food and beverage sectors will ensure modest growth. The group also made a couple of acquisitions in these highgrowth segments which we expect to contribute about R900 million to revenue in FY16.

Bulk land sales of surplus property have been a big help to AECI, compensating for the poor performance from its main divisions. In the absence of further land sales we expect earnings to remain flat in FY2016.

Applying the above estimates to our discounted cash-flow model we value AECI’s shares at R98.57, which falls in the hold region. The group paid out an average of 40% of its earnings as dividends over the past five years, excluding special dividends. We assumed this would be maintained and arrived at a dividend of 355c/share for FY16.

Bull Factors

  • West and east African mining sectors remain fairly attractive
  •  Medium- to long-term prospects of open-pit mining remain attractive, bolstered by Eskom’s drive to build new power stations
  •  Increased footprint in Africa improves diversification

Bear factors

  • Global economy and commodity prices remain weak
  • Labour disputes in South African mining industry likely to affect mining volumes
  • Cost pressures in mining are precipitating contract reviews or re-tendering

Nature of business: AECI is an explosives and specialty chemicals group servicing the mining and manufacturing sectors. It has 58 plants in 34 sites in Africa, southeast Asia and South America.

Disclosures: The analyst has no financial exposure to the instrument discussed. The opinion represents his true view. For Intellidex’s full disclaimer, methodologies and definitions please click here.

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