Few small-cap stocks have been more frustrating that RCR Tomlinson (ASX: RCR). The infrastructure services stock soared in 2016 and 2017, then crashed this year after two projects soured. Now RCR looks like a takeover target for a larger rival or private equity firm.

Turnaround idea

I first flagged RCR as a turnaround idea for the Switzer Report in May 2016 at $1.10 a share and wrote about it again a few months later at $1.71.

RCR soared to $3.59 late last year but my optimism lasted too long into 2018. RCR has tumbled to $1.08 and lost market confidence because of an unexpected contract problem, which resulted in a voluntary suspension from trading in August (reinstated 30 August).

Chart 1: RCR Tomlinson (RCR)

Source: ASX

My interest was based on RCR’s expanding pipeline of solar-farm installation work. The market in 2016 underestimated rising government and utilities demand for solar installations and RCR’s ability to meet it. Solar farms are a growth industry.

RCR started to drift lower in the first half of this year as fund managers took profits. The price nosedived in early August, when RCR announced large cost overruns on its Daydream and Hayman solar-farm project at Collinsville in Queensland, and the resignation of longstanding CEO, Paul Dalgleish.

In its FY18 result released in late August, RCR announced revenue growth of 58% to $2 billion and a $16-million loss. Cumulative writedowns of $57 million from tendered margins on the Daydream/Hayman projects crunched the result and share price.

A bad dream

A confluence of unexpected events turned the total $315-million project into RCR’s worst nightmare. Bad weather, external delays and worse-than-expected sub-surface conditions (than allowed for in the tender) led to large writedowns that RCR only recently identified.

Worse, RCR said a small number of on-site personnel circumvented its standard processes and systems for procurement commitments.

That raised doubts about RCR’s governance of large projects, its organisation culture, risk profile and whether there could be cost overruns at other projects. Investors dumped the stock because they knew RCR would need to raise capital to fix the mess.

In late August, RCR announced a $100-million capital raising to strengthen its balance sheet and avoid breaching debt convents. Small-cap companies and urgent capital raisings are never good for existing shareholders. Deeply discounted shares have to be issued to attract capital, badly diluting shareholders because many more shares are now on issue.

RCR issued shares at $1 – a horrific 64% discount to the stock’s last trade before the capital raising at $2.80. RCR now trades at $1.10, the price when I first wrote about it in 2016 for this Report. Over three years, RCR’s annualised total return is negative 11%.

The company’s rise and fall provides two lessons. One, be ready to take profits on small-cap stocks when they soar and to sell when momentum turns. Two, understand the risk profile of mining or engineering service companies that are rapidly winning contracts. The contract news boosts the share price, but poor execution can wipe out gains.

Predators will circle

RCR has much work ahead to restore market confidence. A new CEO needs to be appointed. Bruce James, an RCR board director, stepped in on an interim capacity. He and the board, in fairness, have been upfront about the problems and response, and provided plenty of detail.

The big issue is assuring the market that similar problems do not lurk in other RCR projects, a factor that could deter suitors from making a bid. RCR’s project problem was more than a usual cost blowout; it suggested the company was taking on too much risk, too quickly.

Another issue is the loss or delay of new contracts because of RCR’s suspension on the ASX and the negative publicity around project losses. The adoption of new accounting standards will also reduce RCR’s earnings, although that is well known to the market.

My hunch is that the share price plunge will spark a class action for damages from affected RCR shareholders. RCR says it is not aware of a potential class action, but the number of class actions around alleged disclosure breaches in Australia is climbing. A hefty settlement is possible, although that risk is presumably insured under RCR’s directors’ and officers’ liability cover.

Longer term, the board has sensibly indicated that RCR will reposition to a more acceptable risk profile. Greater exposure to rail and other transport sectors, which tend to have higher margin predictability, is a goal.

RCR also wants greater adoption of alliance-style contracts, which, in theory, better unite suppliers in a large contract and more evenly share risks and returns.

RCR needs a lower risk profile after its wild ride. But that almost certainly means a slower rate of earnings growth and no quick share price turnaround. Predators might wait to assess how RCR responds to the problem and for clarity that its other projects are unaffected.

Potential upside

There is some good news. Construction on the troubled Daydream/Hayman project is substantially complete. RCR’s internal investigation found no internal evidence of fraud or collusion. It says the procurement control issues identified are not systemic in RCR.

That’s important. The market needs to know problems were isolated to Daydream/Hamilton and not symptomatic of wider issues within RCR. The market is in no mood to learn of other project time bombs within RCR, having supported its capital raising.

RCR says the troubled project is expected to complete in line with current estimates, meaning most of the damage is probably done. The $100-million capital raising and $25-million increase in working capital facilities, shores up the balance sheet if further problems arise.

RCR still has an order book of $1.1 billion and is a preferred contractor of $2.7 billion of work. The company is shortlisted on the Sydney Metro Linewide project and is a preferred contractor on several large rail projects.

About a third of RCR’s $3.8-billion work pipeline (order book and preferred contractor status) includes alliance-style contracts, a big increase on past years. That means more of RCR’s work should have greater profit-margin visibility in coming years.

The key question, as always, is valuation and whether the market over-reacted to RCR’s problem and is factoring in too much bad news.

An average price target of $1.85, based on the consensus of four broking firms (too small to rely on) suggests RCR is materially undervalued at the current $1.10. That looks far too optimistic.

Share valuation service, Skaffold, values RCR at 80 cents a share in 2019 and $1.10 a year later. Prospective investors should watch and wait for better value, and for RCR shares to stabilise and build a base from which the price can eventually start to recover.

That said, a larger predator could view RCR as a neat bolt-on acquisition, assuming it is confident the problems are contained to Daydream/Hayman. RCR still has a billion-dollar order pipeline, good client base, valuable relationships and a mostly solid project record.

Downer EDI has been mentioned as a possible suitor. My sense is that RCR is more likely to be snapped up by a private equity firm that can privatise the company, fix it and sell it via a trade sale or return it to the market through an initial public offering (IPO).

For all its problems, RCR is strongly leveraged to Australia’s unfolding infrastructure boom. Transport projects are booming and renewables infrastructure has good prospects.

That might be enough to attract a suitor that would presumably have to offer a decent premium to the current price to secure board support for any takeover bid. 

Portfolio update

RCR is added to the Switzer Report takeover portfolio this month. Personal hygiene goods provider, Asaleo Care, a recurring disappointment, has been dropped.

• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor All prices and analysis at September 12, 2018.

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