One for the watchlist

I like the concept of investing along a theme. It’s not new, but the strategy involves picking a trend then trying to spot companies exposed to the idea. You can often find a number of businesses in a particular market segment so either pick the best or spread your risk and buy everything. Two themes I’ve used successfully include agriculture – a contrarian play as the sector was then, as now, in the grips of drought – and smaller retailers who were expanding their store networks.

My latest theme is water, something very topical at the moment: we even have a new
Federal Minister for Environment and Water Resources while there have been some research papers on the economics of water released in the last few months. For one example, see ANZ’s Water use and regulation.

Regardless of what happens to control of the Murray River it’s very likely that there will be more construction of water treatment plants for recycling and desalination. While household consumption of recycled water will be some time off, industrial users won’t be too far away if the costs stack up. Companies with proven expertise in these projects should be front runners to pick up some business, while there will also be opportunities for companies who supply and install pipes. Some of the obvious candidates who should benefit from new projects are listed below:

1. Leighton


2. Multiplex


3. United Group


4. Transfield Services


5. GUD

But these are all bigger companies and it would take a few large projects to make a real difference to long term value. I like the idea of tackling some of the smaller players who might be more leveraged to new projects, and one that came up was Cardno (CDD), a firm with a background in engineering consulting but these days also involved in international assistance programs. If you know a little about Coffey (COF) you’ll find Cardno’s story familiar.

Cardno came to my attention through its involvement in the Gold Coast desalination plant but they are also working on the privatisation of the Abu Dhabi Sewerage Service in the UAE amongst other water-related things. If we start thinking about what Australia will need to do with water, these are exactly the type of skills required.

Their market cap is about $300M so maybe two-thirds that of Coffey and generating revenue close to $200M. Unfortunately it’s priced for growth with a capital G. I calculate Cardno needs average growth in earnings of around 17% over the next 10 years to justify current pricing of $6.12 or so. With the number of acquisitions undertaken in the last few years it’s not necessarily impossible but it’s also a big ask. That’s a shame, late last year it was under $5.00 and would have been a good pick up.

I like the mix of businesses which looks nicely diversified across different sectors making direct competition tricky. I like the skillset they own with the experiences gained overseas easily transferable to wherever growth is occurring and I think the specialised consulting services industry is quite fragmented providing opportunities to mop up and eventually expand margins.

One of the problems this type business can face is that while growing quickly they often chew up enormous amounts of working capital, a function of the accounts payable cycle (think wages, contractors etc) being a lot shorter than the collection cycle which on large projects can be measured in months rather than days. As a consequence, they are more likely to tap the markets for an equity top up and profit growth can’t always match revenue growth because of growing interest expenses. In Cardno’s case gearing is reasonable at 55% (June 06 figure, net debt) but interest cover is good at more than 5x so they could take on a bit more debt. Once the growth phase slows and investment in working capital stabilises the firm should be able to generate more surplus cash and paydown debt fairly quickly.

I think it’s expensive at over $6.00 having run up strongly in the past couple of months but I’m interested enough to add it to the watchlist and keep working on my research. If the growth embedded in the price comes back to low-mid double digits or new information comes to light I’ll be interested.