Applying Just Culture to improve investment decisions

Thursday, 13 December 2018

Looking for trouble at RCR Tomlinson (ASX:RCR)

RCR Tomlinson, Engineering, Solar Farm, Darling Downs
Darling Downs Solar Farm

14/08/2019

Trav Mays
 



RCR Tomlinson (ASX:RCR) recently entering voluntary administration, whilst potentially devastating to a large number of people, the thousands of employees and shareholders especially, offers a great learning opportunity. This post will try and identify any potential early warning signs that we may be able to use in the future when examining businesses. This post won’t be an examination of the managers or the operations of the business, it will be an investigation searching for any early warning signs within the financial statements only.

Whilst doing this examination, I have tried to put myself in the position of the shareholder. However, given that I know the final result I am obviously heavily influenced by hindsight bias. With this in mind, I would like to make it apparent that I am in no way criticising any person for either purchasing or hanging onto their shares. Whether a person decides to purchase or to retain a portion of a business is governed by many things, such as their risk tolerance, expertise, level of knowledge, etc. I have made many mistakes, mostly recently Donaco (read about that one here), my desire is to learn from history (it’s a shame that we learn more from mistakes than successes), not to criticise any market participant. Unfortunately learning from history is easier said than done, as Mark Twain said “History doesn’t repeat itself but it often rhymes”.

Company

RCR is a 120 year old Australian Engineering and Infrastructure Company, working with some of the world’s leading organisations to provide intelligent engineering solutions to the Infrastructure, Energy and Resources sectors. “RCR’s core capabilities encompass; development, engineering, procurement, construction (“EPC”), operation and maintenance of major infrastructure and resource projects. These include power generation plants (using a wide range of fuels; solar, wind, battery and hydro), water and waste treatment systemsrail and road tunnel infrastructurerail signalling and overhead wiring systems, mineral processing and material handling plantsintegrated oil & gas services (both onshore and offshore), supply of RCR proprietary materials handling and process equipment, and property services including facilities managementHVAC and electrical services1.

They have had a wild ride in the stock price, recently reaching highs not seen since just before the 2007 bust and the 2014 oil price dive with a subsequent fall similar to that seen in 2008.

ASX RCR Tomlinson Share price
RCR Tomlinson's Share Price

Warning Signs

Gross Margin

The gross margin showed clear signs that something wasn’t right at RCR and that further analysis was warranted. As you can see below, after improving their gross margin to a very impressive 9.9% in 2014, it fell dramatically, to 5.1% in 2016 and continued on its downward trajectory to 1.34% in 2018.

Gross Margin RCR Tomlinson
RCR Tomlinson's Share Price

Gross margin between 2018 and 2015 was being squeezed due to a disproportionate increase of revenue (93%) and cost of sales (111%). As you can see in Table 1, the main culprits up to 2018 for the increase were materials and other costs with employee benefits further exacerbating the expense in 2018.

Cost of Sales RCR Tomlinson
RCR Tomlinson's Cost of Sales

Breaking this down further in to RCR’s operating segments, it is clear that the initially it was just the energy segment, reducing its EBIT margin to 1% from 5% in 2016. The energy and resources segments include RCR’s power generation and mining operations, as with all companies operating in these segments, they were hit hard by the extreme drop in the oil price in 2014. The 2018 recovery of energy would be partly due to the recovery of the oil price, with WTI crude reaching a high of US$74/barrel, still far shy of the pre 2014 crash highs of US$105/barrel.

Segment Gross Margin RCR Tomlinson
RCR Tomlinson's Gross Margin

One of RCR’s main core capabilities of the infrastructure segment is the renewable energy systems, where they offer all engineering facets, design, construction, commissioning, operation and maintenance. Whilst the administrators are still examining the firm’s financials for the cause of their recent troubles, it is believed that RCR took on renewable energy contracts without a firm understanding of connection risks. Along with this, it has been stated that they offered fixed contracts, resulting in all project over run costs being borne by RCR. These two underlining issues came to fruition in 2018, resulting in a large loss for the infrastructure segment of $9.8mill, far below the trailing 4 year average profit of $30mill. This is especially troublesome for RCR, as over 70% of their EBIT in 2017 was generated in the infrastructure segment.

Segment EBIT RCR Tomlinson
RCR Tomlinson's Segment EBIT as a % of Total EBIT

Trade and other payables

Another troubling sign was the huge increase in trade and other payables, increasing from 35% of equity in 2016 to 110% in 2017. Between 2009 and 2016, trade and other payables was an average 46% of equity, between 2017 and 2018 it increased to 116%. Interestingly, as their trade bills increased they continued to pay down their borrowings, reducing their borrowings/equity ratio by an impressive 73.5% between 2014 and 2018.

Debt/Equity RCR Tomlinson's
RCR Tomlinson's Debt/Equity

Discussion

In 2016, the reduction in gross margin could be attributed to an unfortunate project running over time and/or cost, but when the trend continued in 2017 a deeper evaluation was clearly warranted. This evaluation would have unearthed the huge increase in trade and other payables, this along with a shrinking margin should have been a huge red flag for owners, signalling that something wasn’t right. It’s easy to type this after the fact, I too could have been persuaded by the rising share price, as it trotted it was up to a 249% increase in a year and a half. Along with this, a lot of great analyst believed the same and typically when they are all in agreeance, they are usually right. Unfortunately on this occasion they were not.

I could continue to say things such as they should have renegotiated their debt and paid down their trade and other payables, focused more heavily on increasing the energy margin, or sold it off as it was only making a small percentage of EBIT, but these and other similar statements are built on assumptions made on hearsay and speculation. We will need to wait for the report from the administrators to make a full examination.

The main thing I learnt from this analysis is that trends hold the key to finding issues and signs of areas that require a deeper dive into the weeds. It also further highlights the need for us to do our own analysis and to not be swayed by share prices. Once the analysis has been completed, then compare it to the price you calculated, if it is too high, sell, if it’s low and gives you a good margin of safety, buy.

      
I am on Twitter  and Linkedin  if you’d like to connect, feel free to send me a msg, it’s always great to meet other ASX investors, especially those who have a different view point.


Thanks for reading


Just Culture Investor


Trav Mays


   1. https://www.rcrtom.com.au/about-rcr/

This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action  
Location: Brisbane QLD, Australia

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