AusGroup Limited - MANAGEMENT REPLY: Are the problems over for AusGroup?

9/1/2014 – AusGroup has raised fresh cash and fully repaid its debt facilities, after an awful 2013 calendar year marked by weakening fundamentals and problems with existing customers and new orders.

But that doesn't mean it's out of the woods yet.

A recent report by PricewaterhouseCoopers (PWC) on the Australian mining industry said that it was a challenging year for the mid-tier 50 companies.

Falling commodity prices and increased costs impacted the bottom line.

These conditions resulted in declining investor confidence, and have seen the combined market capitalisation of the mid-tier 50 plummeting 50% in two years.

So, even companies are not into mining but provides services to companies operating in this sector are invariably exposed to the same risks.

AusGroup Limited, a fabrication and manufacturing company, is not directly involved in the mining business but its exposure to mining sector has torn apart its fundamentals.

DMG OSK Research was bullish on the group until May, after which it downgraded the stock to SELL with a target price of S$0.35, citing weak order flows.

It recently slashed the target price to S$0.18 as problems were magnified when it did not receive payment for its major project, Karara.

As a result, it was unable to recognise revenue in a timely manner which impacted the earnings before interest, tax, depreciation and amortisation (EBITDA).

This created liquidity problems and various ratios were affected that lead to a breach of certain debt covenants.

In addition, the group is also experiencing cost overruns in other projects and a delay in commencement of new contracts.

So, AusGroup sold its property in Tuas Road and will issue new shares.

In fact, the stock price recently bounced back from S$0.18 after the fund raising exercise was announced on January 3.

Let us dig a little into AusGroup's exposure to the mining sector.

Delay of payment from Karara Mining Limited

Karara Mining Limited (KML) is a joint venture between Australian-listed Gindalbie Metals and Chinese steel giant Anshan Iron and Steel (AnSteel).

According to AusGroup's website, the contract from KML was in excess of A$200 mln - the largest project by value in the last two years.

But in May, it announced that KML withheld A$21.7 mln of progress payments and intended to call on the performance security amounting to A$8.8 mln in the form of bank guarantees.

In addition, it also received notification from KML of a claim for an un-finalised value.

AusGroup clarified saying that the claim was not given in accordance with the contract and KML had not provided any formal substantiation.

Furthermore, it had performed this contract in past and KML had not issued any formal "show cause" notice under the contract.

The group then filed a case against KML in the Supreme Court of Western Australia for non-payment of progressive payments of A$43.5 mln and performance incentive of A$11.2 mln.

In addition, it was granted an interim injunction to restrain KML from converting the securities worth A$8.8 mln into cash.

Thereafter, a progress payment of A$13 mln was paid by KML in July 2013 and also saw the return of an outstanding bank guarantee worth A$10.9 mln.

It further received A$18.3 mln in September.

This makes us wonder whether AusGroup is at any fault and KML is intentionally delaying payments.

This can be inferred from the on-going problems at Gindalbie which made a loss of A$144.4 mln in FY13.

The Karara mine is facing delays due to significant cost blow-outs and problems with its tailings system that continue to hamper the operation.

Hence, it requires significant extra work and more funding to fix.

Does it mean that AusGroup's problems are short term and management will be able to resolve it soon?

The company announced earnings for Q1 FY14 on November 12, 2013:

Revenue: -50.4% to A$77.2 mln
Gross margin: -27% vs 14%
Profit (Loss): (A$15.1 mln) vs A$6.3 mln
Cash flow from operations: A$22.4 mln vs A$16.4 mln
Order book: A$219 mln

Revenue fell across all divisions because of the downturn in mining services and not securing targeted projects.

However, cost of sales decreased by 26.8% to A$98.1 mln due to adjustment made for additional costs being identified and accrued in terms of loss making contracts.

Investor Central. Asian insights for global investors. We ask the tough questions of Asian companies which global investors need answers to.

Question

1. Are the problems over for AusGroup?

AusGroup witnessed its worst year ever, with the share price falling 73% from S$0.66 to S$0.18.

All thanks to weaker mining sector, a slowdown in China and lower iron ore prices that lead to delay in payments from KML.

These issues, among others, shook its balance sheet from net cash to net gearing of 10% in FY13.

However, AusGroup seems to have started 2014 with a bang.

It just announced the placement issue and has fully repaid its debt facility.

It will now focus more on growing in the oil and gas sector.

However, winning more contracts, possibly a bigger contract, is the key to lift its fundamentals.

Management reply: CY13 was certainly a disappointing year. The downturn in the mining sector has occurred more quickly than anticipated and impacted our growth aspirations. To this end, we have been busy restructuring our business and focus with a distinct bias towards the Oil & Gas sector and providing integrated services for our client’s asset management programmes. The conversion of these opportunities will drive sustainable future performance and rebuild the balance sheet. Importantly though, it is the integrated services that is the underlying core business of the AusGroup, while the provision of SMP construction services was opportunistic during the increased activity provided by the mining boom over recent years.

Question

2. Which contracts are loss making?

AusGroup said cost of sales decreased due to adjustment made for additional costs being identified and accrued in terms of loss making contracts.

Management reply: We refer you to our SGX Announcements. [As disclosed previously, we encountered issues on the CSBP Ammonia Nitrate (CSBP) and Gorgon Pipe Spool (GPS) projects. The CSBP project has now received practical completion and was completed within the revised forecast we established for Q1 reporting, while progress on GPS remains on track.]

Question

3. Is it planning to restructure its labour costs?

The group highlighted in its Q1 FY14 profit guidance that operational restructuring was one of the reasons for losses.

It said the overhead costs have now been substantially reduced in order to protect the group's future profitability.

This was visible in administrative expenses which fell 7.9% to A$6.7 mln.

However, its labour costs seem to be high as the cost of sales hasn't fallen in proportion to the fall in revenue.

If it does not secure sufficient work, the company will eventually need more working capital to maintain its workforce.

Management reply: With a change in strategy comes a change in structure. As a result, we incurred restructuring costs in Q1 as disclosed in our SGX Announcement for the Q1 Results. The cost of sales you refer to impacts Gross Margin and reflects the losses referred to above. The administrative costs are falling and are in line with our projections.

Question

4. What lessons did it learn from the KML episode?

AusGroup's problem started from KML's delay in payment, but at the same time it was the largest project by value in last two years.

Management reply: As this matter is still in dispute, we do not wish to comment further than to say that strong Client communication is key to pro-actively addressing issues.

Total number of questions in the full story: 20

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