|Shares Out. (in M):||85||P/E||0||20|
|Market Cap (in $M):||550||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
DIRTT was written up twice on VIC by Mason in 2015 and tim321 in 2017, and so you can review those writeups to get a sense of the company. As a result, I am not going to rehash the business summary in a lot of detail and instead will focus on how the company evolved, what has changed and where we will end up over the next few years.
DIRTT grew revenues between 10% and 25% in each of the past three years, while the stock price has been going sideways over this timeframe. Then a logical next question why has the stock been flat in spite of good top line performance. The answer is tied to the prior management team, and that they have spent like drunken sailors without regard for profitability. And hence my thesis over the the next few years that the new team is very likely to drive profitability and free cash flow growth. In essence, the shareholders now should reap the benefits of company’s prior investments that should drive both future revenue growth and margin improvement.
DRT stock fell nearly -20% on January 1, 2018 after the Board fired both Co-Founder & CEO Mogens Smed and President & CFO Scott Jenkins. Our interpretation of what transpired is that Mogens co-founded Dirtt and ran it as a family owned business. As a result, he used Dirtt to build him a multi-million dollar home and expensed $3.8m of the house cost as an R&D expense. I am not even going to try to explain how the Board approved this construction in 2016 or why the cost came as a surprise but the final outcome was that the board relegated CEO to a sales role and fired the President Jenkins. An interim CEO and CFO were named immediately. All other management team members stayed in place.
In addition, an activist fund launched a proxy battle in March, and the Board settled by appointing two new shareholder friendly board members. One of the new board members, Jack Elliott, brought on the DIRTT’s new permanent CFO at the end of May. Jack was Pure Technologies’ CEO when Geoffrey was the CFO, and then Pure was acquired at roughly 100% premium earlier this year by Xylem. We believe Geoffrey Krause is what Dirtt needs - he is process driven finance exec and has focused on implementing new systems and driving cost savings in his prior role at Pure. We have spoken to Geoffrey and he sees many similarities between DIRTT now and Pure when he joined them in 2014 before the new systems and cost savings were implemented.
Because of the management turnover, the stock has not recovered fully and is still below the December 2017 price in spite of, in our view, positive changes to the story. There is some uncertainty since the company has not yet appointed a CEO and is now run by an interim CEO. We have spoken to the board members, prior CFO Derek Payne, president Scott Jenkins, interim CFO Peter Henry, COO Tracy Baker, new CFO Geoffrey Krause and do not think that there are any accounting issues or any other irregularities.
As alluded to above, the previous management team did not focus on profitable growth, which is now the number one goal for management. The company is now finishing its CEO search and should announce a decision in the coming months. Given the stellar operating performance in Q1 and new systems-focused CFO, we think the business is in good hands in the short term and the board is smart to be meticulous about choosing a new CEO.
DIRTT’s value proposition is multi-faceted: greater building accuracy, better budgeting abilities, and faster lead times. Simplistically, everything typically arrives in three weeks and there are no cost overruns. The accuracy comes from the company’s software that is used to model projects in 3D so that all components are measured and built with great precision. I will refer you again to Mason’s write-up for an in-depth analysis of this technology. This unique capability lends itself to the other key differentiators of being faster than the alternatives and sometimes cheaper. This exactness allows DIRTT to immediately lock in prices from the onset of a project, something essentially unheard of in the construction world. Similarly, this process lowers the lead time even though everything is made custom for that project. What takes a normal building company 3 months to accomplish, DIRTT can do in 3 weeks because of this technological advantage. This superior process attracts buying interest from all industries with past customers ranging from Cleveland Clinic to Netflix and Apple.
The top line growth story is not a change for DIRTT, and what makes this company so interesting now is the levers this new management team can pull to drive profitability. Management has guided for an EBITDA margin for this year between 13% and 15%. Given that the company posted a 15.8% margin result in Q1, we believe that the high end of the 2018 outlook is likely. The interim team was able to restrict SG&A growth to 1% ex-reorganization one-offs by lowering duplicative costs, travel expenses, and corporate overhead. There is still low hanging fruit that the new CFO will be able to cut out over the next year beyond the quick fixes that were implemented.
The other key cost that will stabilize is the sales team, whose headcount has been growing rapidly and weighing on margin as the bulk of the hires go through training and are not generating sales. Now, the majority are contributing to winning new business as is evidenced by the backlog, which management claims is at record highs. Company discloses the personnel expenses to be a little under half of total SG&A, so as revenue continues to grow and this cost stabilizes, we should see SG&A % of sales fall steadily. With revenue growing at roughly ~15% per annum, the personnel costs should only grow at ⅔ that rate. The selling commissions should be roughly 5-5.5% of revenues. The remaining general and administrative costs mostly relate to overhead, which we seeing growing at about ⅓ the rate of revenue after cost cuts in 2018.
In addition to cost control, we see a ramp in utilization as a key driver of operating leverage and greater profitability. DIRTT has been increasing its production capacity at a greater rate than sales the past few years. With square footage growing nearly 50% last year alone. At the same time, the internal processes lacked efficiency where the gross margins vary greatly by product. All these factors caused product revenue utilization to drop to roughly 60% for 2017. The new CFO plans to homogenize the manufacturing process to reduce any remaining bottle necks and minimize the variable costs unique to the different products. Coupled with the strong project pipeline, utilization should increase rapidly to at least 70% in the near term and a 75% average over the next few years, which would be a 15% jump from last year. Longer term, the company will continue to grow production capacity at a rate likely in line with revenue growth.
This utilization enhancement will be the main driver for economies of scale in a business with relatively low variable costs. DIRTT had approximately 44% adjusted gross margin in 2016, and we believe the company can expand its gross margin sustainably to 44% by 2020; this is supported by a gross margin of just under that mark in the first quarter. The real operating leverage should come in SG&A as we believe these operating expense will be less than 30% of sales in 2020 from 40%+ in 2017. This may seem like a tall order, but the interim management team was already able to cut this to 35% this past quarter. With an aforementioned 75% of SG&A being fixed, we think this 500 bps cut is reasonable. This means a 2020 EBIT margin of roughly 15%; this would show a company completely transformed after only posting a 1.5% margin last year. At this time, growing profitability is the key initiative going forward for the business.
DIRTT is a technology-driven disruptor trading at an attractive valuation. Additionally, enterprise value is just below $500 million and less than the market cap due to the company being debt free with almost $70 million in cash on the balance sheet. Using the assumptions from above of a 15% revenue CAGR and 15% EBIT margin, we arrive at operating income of roughly $70 million and the resulting valuation is an EV / 2020 EBIT of approximately 7x. On 2019 basis, DIRTT trades at an EV / Sales is 1.3x and the P/E of about 20x, which results in a PEG of 0.6x given the estimate of 35% earnings growth.
We believe these valuation multiples are cheap for for a business with a strong value proposition. Moreover, the stock is down YTD after announcing its management changes early in the year that surprised investors. As we explained above, the changes are likely positive for the company, and the business fundamentals remain strong.
-Always a risk integrating a new CEO, but we view this as an opportunity and believe that the new search committee to make a good decision with the appointmentLumpy revenues. -The nature of this order driven business will create volatility in the top line quarterly. Even with shorter lead times, timing issues can push certain products in or out in any given quarter
-Cyclicality of construction space. While we believe DIRTT is a differentiated business that should outperform traditional building companies, it will still be sensitive to the overall industry
-Aluminum is roughly ~15% of COGS so it could be a short-term headwind but the company can generally pass raw material prices to customers
-Full-time CEO appointed. Michael Goldstein has done an ok job as a stand-in with operations humming along nicely now. A leader for the long-term is the final component needed for DIRTT long-term trajectory
-Healthcare category and other big projects may drive top line acceleration for the remainder of 2018
-Profitable growth sustained over a period of time. Creating a track record of profitable growth will drive investor interest