AECI is South Africa’s largest explosives manufacturer and a dominant player in the specialty chemical industry. The group has a long history in the South African mining landscape having been formed in 1924 with its main purpose to provide explosives and detonators to the gold and diamond industries.
While explosives and mining chemical solutions remain the largest contributor to operating profit (69% in 2017), the group has been diversifying its revenue stream after the financial crisis (2009) through a series of acquisitions both locally and internationally. The introduction of several new strategic pillars was aimed at reducing exposure to the highly cyclical South African mining industry to gain exposure to new growth areas.
Figure 3. AECI Operating margins.Source: Company financial reports, Northstar Asset Management.
New strategy enhancing the group’s moat
AECI has seen a strong improvement of its mining solutions business over the past year driven by a recovery in commodity prices and increased output from miners. Operating margins have improved in 2017 as operations in South Africa, Asia Pacific and the Rest of Africa recorded robust volume growth.
Notwithstanding improved trading conditions, the South African mining explosives industry, while fairly consolidated, is highly commoditised despite efforts from players to improve customisation and service offerings. Customer concentration and intense competition, in our opinion, have made it difficult for explosive companies to maintain a consistent competitive advantage in the industry. Operating margins, (Figure 3) have tended to be volatile through the cycle and not shown structural improvements despite efforts from AECI and other players to automate production and increase capacity utilisation of their facilities.
AECI’s diversification drive, although in its infancy stage, is compelling considering the lower returns on capital and margins of the SA explosives business compared to its chemical business cluster (Figure 4). The revised strategy has resulted in the formation of five operating segments which offer in our opinion exposure to industries with better growth opportunities and competitive dynamics, namely: mining solutions, water and process, plant and animal health, food and beverage, chemicals (Figure 5).
The improved moat stems primarily from two dynamics, exposure to a larger and more diverse customer base and participation in industries with higher levels of specialisation which lend to better pricing power.
In line with its strategic framework, AECI in 2017 concluded two acquisitions which will significantly impact the group’s results going forward. The first is Schirm, a German agrichemical manufacturer with a footprint in both Germany and the US. It was acquired for a consideration of ZAR1.9bn on an EV/EBITDA of 8x which compares favourably to other European chemical companies that trade on 8-10x multiples. Management sees several synergistic opportunities, including the replacement of some raw materials currently imported into SA from third party suppliers as well as the substitution of SA exports to European clients.
The second transaction relates to the acquisition of Much Asphalt (still awaiting competition approval), which according to AECI is South Africa’s largest supplier of hot and cold asphalt to the road construction industry. The transaction consideration of R2.2bn implies an EV/EBITDA of 7x (compared to AECI’s trailing multiple of 6.6x). The business will be integrated into the chemical cluster and management is confident of synergies in SA as well as being able to take advantage of opportunities in Africa.
Figure 4. AECI Operating profit to assets. Source: Company Financial Reports, Northstar Asset Management.
Management team
AECI’s management team is well established with Mark Dytor having assumed the role of CEO in 2013 and Mark Kathan occupying the role of CFO since 2008. The executive has been, in our opinion, effective in managing costs and working capital over the past five years which has translated into strong free cash flow growth and improved returns on assets, while maintaining an ungeared balance sheet.
Figure 5. Segmental Revenues. Source: Company Financial Reports, Northstar Asset Management.
While we are supportive of management’s acquisitive strategy, we are cautious of its execution as it introduces two new risks to our investment case. The first is the potential to overpay for acquisitions which may adversely impact returns on capital. The second is increased gearing (debt) in an inherently cyclical business. While we acknowledge these risks and are monitoring this very closely, we believe that the management team has so far, maintained financial discipline, set realistic targets and communicated transparently with investors. A final consideration to note with respect to corporate steering, is how the AECI management team’s incentive structure works, it is largely driven by HEPS (Headline Earnings per Share) growth. We believe this is an incorrect incentive approach as it encourages the pursuit of value destructive acquisitions. At the heart of any successful management incentive structure in our opinion, should be growth in shareholder returns on capital as well as growth in free cash flow.
Valuation
The group is highly cash flow generative, it trades on a free cash flow yield of approximately 5%. With respect to other valuation metrics, on an EV/EBITDA basis, AECI is rated at 6.1 times against its long-term average of 6.5x, the P/E is currently 12.6x – we consider this fair.