South Africa

Aveng looks cheap – but there is a catch

Aveng released its annual results for the year ended 30 June 2022, which revealed an increase in revenue from R25.7 billion in 2021 to R26.2 billion in 2022.

The company reported a second consecutive year of profitability with headline earnings of R308 million, down from R751 million in 2021.

Despite reasonably good results, the infrastructure, resources and contract mining group – formerly known as Anglovaal Engineering – is a shadow of its former self.

Aveng used to be the largest construction company in South Africa, but tough economic conditions and own goals gutted the company.

It was involved in a construction collusion scandal involving numerous large projects and racked up huge debts as part of its global expansion strategy.

When the South African government cut its infrastructure spending, the local economy stagnated, and the commodity market experienced a downturn, Aveng started to suffer.

In September 2017, chief executive Kobus Verster resigned with immediate effect after Aveng reported a net loss of R6.7 billion.

The market has lost trust in the company, and Aveng’s share price has declined by over 99% over the last decade.

Aveng implemented a turnaround plan in 2018, which included disposing of non-core assets, cutting costs, reducing debt levels, and improving its operational performance.

The strategy showed good results. In its 2021 financial year, Aveng raised R492 million through a rights issue, reduced debt by R1 billion, and recorded its first headline earnings since 2014.

The stock became a favourite among punters who saw it as an outstanding penny stock to make a quick buck.

However, as significant challenges remained, the Aveng share price plummeted nearly 50% over the last year.

It did not stop many investors from looking at Aveng as a good stock that could offer outsized returns.

Portfolio manager Dylan Bradly recently highlighted in a Twitter post that you could get Aveng virtually free.

It has cash balances of R2.617 billion and has reduced its debt from R879 million to R481 million. Meanwhile, at the current share price, Aveng has a market cap of around R2.06 billion.

In technical terms, its means Aveng currently has an enterprise value – also known as the takeover price of a company – of -R76 million.

The negative enterprise value means you are effectively being paid to take the company.

An analogy is buying a house for R1 million, and while it’s a fixer-upper, the realtor tells you that there is a chest with R1.2 million in cash in the basement. So, the owner effectively pays you to take the house.

If this sounds too good to be true, you would be right. It is, therefore, instructive to delve deeper into Aveng’s finances.

Aveng has indeed reduced its direct borrowings, but it is still on the hook for other liabilities.

Trade payables increased from R3.081 billion to R4.149 billion. Most of the increase is attributable to its Trident Steel business segment, which was previously classified as held for sale.

Similarly, long- and short-term lease liabilities have increased from R519 million to R1.039 billion, which is again attributable to Trident Steel.

Aveng also reports liabilities on existing construction contracts of R1.699 billion.

According to CapitalOnePartners, these numbers can be severely underestimated due to the nature of construction and engineering contracts.

Contractors can be on the hook for significant re-work if mistakes are made. The cost of this re-work on large contracts can easily bankrupt companies, even if they have healthy balance sheets and cash reserves.

Companies in this industry have high working capital requirements to fund construction work before reaching milestones where they can get paid.

Given Aveng’s strong order book, most of this cash pile will likely be earmarked for growing the company, led by its McConnell Dowell segment in Australia.

In summary, Aveng has done well to improve its financial situation and might offer promising growth prospects if it can successfully deliver on most of their contracts without costly mistakes.

However, it comes with significant risks, which is why the market remains bearish on the company.

Negative Enterprise Value Companies as a Strategy

While the occurrence is rare, negative enterprise values happen, and buying them is considered a deep-value strategy.

A study done by Alon Bochman, CFA revealed that between 1972 and 2012, there were 2613 US stocks with an enterprise value that was negative on average for just over ten months.

Bochman found that if he bought these stocks when they had a negative enterprise value and held it for 12 months, he returned an average of just over 50%.

The returns of this strategy were far better than the index.

However, there are still significant risks. Companies have negative enterprise values because they are going through financial difficulty.

It is unclear whether the Bochman study accounted for survivorship bias.

Bochman might not have included all the companies whose enterprise value went negative before the company went bankrupt and delisted.

A replicating study done by Broken Leg Investing found that they had to diversify over many companies for this strategy to work effectively.

They also noted that there were certain investment periods where this strategy underperformed and that investors sometimes needed to withstand portfolio drawdowns over 70% before the strategy paid off.