A Rustle In The Grass May Have Awakened Private Equity To Coates' Presence

The Age

Tuesday June 12, 2007

Stephen Bartholomeusz

THE timing of Coates Hire's announcement of a profit downgrade last week couldn't have been more unfortunate, given the stalking of the company by private equity.

The downgrade was so modest - earnings are likely to come in at less than 5 per cent below the lower end of the guidance Coates gave in February, with underlying profit still likely to be at least 7.5 per cent ahead of last year - that in normal circumstances the company might not have bothered providing an early-warning signal.

Coates' circumstances are not, however, normal because the company revealed in May that it had received "preliminary approaches" from interested parties, including private equity firms. It responded by announcing a review of its strategic options to maximise value for shareholders. Since that announcement, there has been a lot of activity in Coates shares, with more than 30 per cent of its capital traded.

The group, the country's largest equipment hire group, with about 20 per cent of the overall market (nearest competitor Emeco has about 8 per cent) is peculiarly attractive and vulnerable to private equity.

Under its chief executive since 2003, Malcolm Jackman, the group has aggressively expanded and diversified. In the past two years it has invested nearly $700 million in equipment and acquisitions, with the spending running at about 21/2 times depreciation.

The strategy has been clear. Jackman has pursued aggressive diversification - of Coates' geographies, products, sectors and customers - to safeguard the business from some vulnerability to cyclicality. Coates is the biggest equipment hire group in this country and now one of the biggest in its industry globally.

For a while that made the group a market darling. Five years ago Coates earned $33 million. This year, after last week's downgrade, it is expected to earn at least $100 million. The scale of investment in the business, however, has unnerved some of the group's big shareholders, given its impact on returns, and the diversification strategy means that Coates isn't as leveraged to some of the higher-growth segments of its markets as some of its competitors.

The nature of Coates' business means it has to invest ahead of growth - it has to acquire its equipment up front if it is to drive revenue and profit growth in the longer term. The bulge in its capital expenditures has an unavoidable short-term cost to earnings and returns if the group is to be in a position to generate long-term growth.

The capex program has peaked but it will take time for the revenue growth to come through; leaving a window for predators.

The earnings downgrade stems in part from the growth pains the sector and its customers are experiencing. Capacity constraints/bottlenecks in Queensland, including labour and equipment shortages, are short-term issues that should have only a temporary effect. In the group's more resources-focused business, Allied Hire, however, the bottleneck issues, which include availability of equipment, may reflect a more systemic and structural challenge.

The underlying settings, however, are positive. Coates' most important market is construction, which has grown from about $28 billion of activity in 2001 to more than $70 billion this year. Every budget this year, state and federal, has foreshadowed a huge increase in infrastructure spending. The resources boom has until recently been more about the prices received for commodities than the volume growth that drives Coates' growth, but that is starting to change as the big investment in expanded production over the pasty few years starts to come on stream.

There is also the sleeper of BHP Billiton's Olympic Dam expansion. If all goes according to plan, construction of the expansion will begin in 2009. The project, which could cost as much as $10 billion, may be operational by 2013.

Coates is the main on-site provider of hired equipment to Olympic Dam today and is well positioned to win its share of an expansion that will see about a million tonnes of earth moved daily - the equivalent of the country's coal exports. Even if it doesn't get the majority of the contracts available from the project, however, Coates will still benefit from the flow-on effects of the project on the supply-demand equation for equipment and services.

Overseas, the equipment hire industry has attracted a lot of activity from private equity. In this market, Emeco was owned briefly by private equity before it was floated last year. The very things that have led to some institutional disenchantment with Coates - the strategy that lowered the cyclicality and volatility of its earnings at a cost to near-term revenue and earnings growth rates - would make it attractive to a leveraged bid.

As a consequence of its review, Coates will no doubt consider its own options for remaining independent and rekindling market enthusiasm. Its balance sheet would, as the capex program slows, shift towards more conservative settings, so a capital management program might be possible. Asset sales may be an option, as may a strategic play of its own in a highly fragmented sector.

With its share register being increasingly destabilised as hedge funds set themselves for takeover activity, however, Coates isn't fully in control of its own agenda and it may take something very creative from its advisers at Macquarie Bank if it is to escape the clutches of private equity or at least ensure that its latent value is properly appreciated.

bartho@theage.com.au

© 2007 The Age

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