I mentioned SRG Global (ASX:SRG) in the latest monthly write up as a cyclical business that we own. The investment thesis at its core is very simple. In the previous 2 years, the company had generated $75.9m in free cashflow, equivalent to 22% of its market capitalisation currently. After a very strong first half result just announced, it has now generated $103.7m over 2.5 years, equivalent to 31% of the market capitalisation.
Source: Company filings, author’s calculations
When it comes to small cap companies that are spinning off a lot of cash, I am often reminded of a Lyle Lanley quote form the Simpsons: “Y'know, a town with money is like a mule with a spinning wheel. No one knows how he got it and danged if he knows how to use it!”
Companies that are in an industry that is booming, more often than not, tend to expect those boom times to last. This typically leads to spending the cash on acquisitions. That is what we are seeing with SRG Global. In March last year they acquired WBHO Infrastructure for $15.2m and then in December, they acquired Bartek for $2.6m. Now, they have taken a bigger swing with the acquisition of the Asset Care division of ALS.
To understand the evolution of SRG Global, it is important to take a step back and look at how at how they got to where they are. The company has always had big ambitions. Even prior to the company changing merger with Global Construction Services (GCS), the company often listed admission to the ASX200 as a long-term goal. So, an acquisition mindset is not a surprise.
The 2018 merger with GCS did really change the game for SRG. GCS was a hot stock at the time, as its facades business was gearing up for a lot of cladding replacement in the wake of the Grenfell Tower fire in the UK. GCS as the market leader in facades was well positioned to benefit from the remedial work that needed to be done. That thesis has played out over the last few years, remarkably at the same as the rest of the business has grown. All three segments have shown remarkable growth in EBITDA over the last 2 and a half years. In revenue it is particularly noticeable over the last year.
Source: Company filings, author’s calculations
In the first half result, asset services grew revenues by 22% year on year, mining services by 33%, and Engineering and Construction by 30%.
The growth in free cashflow has improved the balance sheet with the company moving into a strong net cash position. Notably, this is also whilst paying a healthy dividend and making the two small acquisitions above.
Source: Company filings, author’s calculations
This of course, brings us back to the mule with the spinning wheel. The company is now in a position to make a sizeable acquisition and that has come in the form of the Asset Care division at ALS. This is a step up from the previous two and comes at a cost of $80m. The company is raising equity as well as using existing cash to fund the acquisition.
The asset care division has been deemed “non-core” at ALS for some time. SRG themselves have been following it for 5 years with an intent of hopefully buying it one day. That opportunity has finally come and the company was the successful bidder in a competitive process.
SRG was attracted to the business as it complements and adds to what they already do in asset services. The ALS business is focused on the front end of asset maintenance with inspection, certifying and testing expertise. Whereas SRG currently fills the backend carrying out repairs and maintenance services. This means SRG can provide end to end asset lifecycle capability. The potential upside of the acquisition comes from cross sell opportunities, synergies, and most notably a renewed focus. The business within ALS has stagnated in recent years given it was “non-core” and at ALS’s most recent result, revenue had fallen 6.7% year on year. Given SRG’s results, this performance was clearly well below the industry.
Given the above, the acquisition looks solid and could provide some short-term upside. We do have to remind readers though that contractor businesses are low margin and cyclical. We can see that in SRG’s recent history.
Source: Company filings, author’s calculations
At some point the cycle will turn and asset utilisation rates will drop which will put pressure on the bottom line. It’s probably best to ignore the pandemic impact above and look to the downturn from December 2016 to 2017 as a more typical one. For now, the outlook is solid and earnings momentum is strong. It is also worth noting that SRG is one of the less cyclical of the contractors given a big focus on infrastructure and that its mining division is focused on production as opposed to exploration (although in a downturn production can be cut as well). Scale also helps with margins and acquisitions, if done well, can provide that scale.
For now, it looks like the mule with the spinning wheel has come up with a winner, however it comes with the caveat that the boom times won’t last forever.