Hey all –
Why do highly levered companies sometimes present great opportunities? I released a pod yesterday with the great Diligent Dollar where he explains why:
DD’s full write-up on this topic is even more detailed than you can get on the pod and I recommend a full read through. I’ve recommended this blog before (I interviewed DD on the movie industry in this episode and on Yelp (why they make a good acquisition target for Angi’s List), Autozone and Trupanion in this episode) but once again – if you can subscribe to just one newsletter, make it Diligent’s.
Our conversation on leverage led to a good back and forth on a delevering story that DD is long on – Civeo. CVEO is a lodging and hospitality business for mining sites (check out this video to get a sense of what they do). Management has been working to decrease debt for several quarters now, and as DD points out on the pod, a dollar paid down of debt is a dollar to the equity. If the company hits the midpoint of 2021 free cash flow guidance each of the next four years, it will earn its market cap back in cash.
As always, do your own work and this stock isn’t without risk – a commodity down cycle would crush earnings and the company is exposed to the oil and gas sector. While researching Civeo, I actually came across this article from 2014 on how CVEO had to cut 1,000 jobs when oil prices unexpectedly tanked. I think this time around that risk is lower since expectations for energy prices have been low for years and the company produced cash in a year when oil prices went negative (in part because capex was its lowest in years).
This also is a company that benefits from coal, oil and natural gas mining. ESG investors won’t be jumping in with you. As this is a small cap, don’t expect to have institutional support.
That said, I like the stock even in a bear case – if FCF is half of the low point of guidance ($50 million on low end, so $25mm) the yield is still 11.5% on the $218mm market cap as of yesterday. In comparison, the S&P yield is 5%. I’m getting twice the value of the market on an FCF yield basis in a draconian scenario.
Re: the aforementioned ESG / institutional support angle – I look to what customers are saying for measuring business quality and not other investors. From the company’s last earnings call from February:
We also had another successful quarter in terms of new contract awards and extensions. Today, we announced 3 contract renewals in our Australian business, with the expected total revenues of AUD 101 million over the 2-year terms.
DD rightfully points out there is significant upside in the bull case. CVEO in a commodity bull cycle could do over $100mm+ of FCF. In 2015, net cash from operating activities was $186mm v. $62mm in capex, meaning FCF was roughly $124mm. Were CVEO to hit $100mm in FCF, I think the company is worth at least $500mm (conservative 20% yield), which gives the stock 129% upside from here.
If you fear the commodity risk but think the cash flow story is still decent, I’d consider selling puts at a low strike. You can get a double digit annualized return and have some downside protection with this trade. DD and I get into the tradeoffs of selling puts versus owning the stock on the pod, so give it a listen if you’re interested.