ECOLOGY AND ENVIRONMENT INC EEI
May 03, 2018 - 5:27pm EST by
mm202
2018 2019
Price: 13.00 EPS 0 0
Shares Out. (in M): 4 P/E 0 0
Market Cap (in $M): 56 P/FCF 7 6
Net Debt (in $M): -20 EBIT 6 8
TEV ($): 36 TEV/EBIT 6 4.5

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  • Bad governance

Description

About a year ago there was a really good detailed write up on EEI by andreas947 (https://valueinvestorsclub.com/idea/ECOLOGY_AND_ENVIRONMENT_INC/140275) which is what got me interested (our fund owns about 1% of outstanding shares) so what I don't want to do is rehash the exact same thing without adding value. So what I'd like to do is do an executive summary and give you my take with some updates, some notes on my conversations with management and why now and this is more of add on discussion than a fresh idea pitch. 

Elevator pitch: EEI is an environmental consultancy with a cash rich balance sheet (close to 40% of market cap), a strong dividend (~3%+ yield), trading at 15% Free Cash Flow yield (EV) on depressed cash flow thats bound for a breakout in next 12 to 24 months, with now TWO activist investor funds involved; with a longer term sale or ownership change catalyst on the horizon. The stock's margin of safety is backed by an implied standing offer of $13-$14 per share (when the company had $5 per share less cash on the balance sheet) by Mill Road Capital that is currently on the board and its low valuation with a potential 250% upside in the next 12-24 months.

Why we like it?

- Asset light consulting business with little fixed cost contracts. Unlike other E&Cs this is mostly a "C" and has ~85% of the business on Cost Plus (37%) and Time and Materials (47%). Its a simple to understand business.

- Solid reputation: been around for 40 years, consistent partner with the big name E&Cs, always invited to bidding table on all new domestic projects

- The dreaded "channel check" word but the reason we've held off investing for a year is because we were concerned about the state of the federal government business with Scott Pruit's EPA and how that could impact EEIs business. For context, of the $70mm in annual US revenues, half is government work ($35mm) and half that is federal government work ($17.5) and while not disclosing the actual numbers of how much the EPA is of that, it is not entirely dependent on EPA but diversified across other federal agencies and military (for example if you're building baracks or upgrading facilities on a base you need an environmental assesment. So part a) was figuring out that the EPA risk was not as big as feared. So b) does this business $10-12mm go away with the "I hate the EPA head of the EPA" and the answer is possible but not probable. Most of the actual issues have been delays in staffing in EPA who move these projects forward, not the cancellation of the projects (per our talk with a regional EPA sr staffer). Additionally there is always sort of permanent Superfund work and the Start IV contract. So I would say in a bear scenario maybe $5mm of that business is at risk. c) Apparently the states have been picking up the work that the federal government has not been doing so its just a shift from federal to state levels. So all those points and conversations asuaged our concern about this business. Per CEO, who is an EEI lifer, they tend to do better under Republican administrations than Democrat ones which makes sense given that Republicans tend to approve more energy projects...

- ... which is the other side of the business ($35mm) is a lot of energy infrastructure work which has been pent up due to lower oil prices and Obama red tape. If you believe $70 oil releases more energy work as management does, this side of the business will do just fine. I am still doing more work on this and I'd like to get through more energy company earnings to hear their commentary on infrastructure CapEx before I put a definitive detailed answer here (under a due date for idea posting) but from everything I've gotten so far there is a lot of pent up demand which should bode well for EEI.

- third leg of business is the $30mm breakeven LatAm business which is essentially Brazil which is coming off a brutal 2 year recession is finally showing signs of growth in 2018 with expectations for ~3% growth in 2019-2020. 

"The Brazilian economy advanced 0.1 percent on quarter in the last three months of 2017, following an upwardly revised 0.2 percent expansion in the previous period and well below market expectations of a 0.4 percent rise. It is the lowest growth rate in four quarters after a 2-year recession in 2017. Considering full 2017, the economy expanded 1 percent, following a 3.5 percent contraction in both 2016 and 2015." - Trading Economics

- Operating leverage: So you have a $100mm revenue business that generates $6-7mm in EBITDA (mostly US, with LatAm at breakeven) on a cost base of $38-$39mm now that Mill Road Capital is on the board and is making sure the 80 year old founders arent paying themselves "board bonuses" of $1mm to $3mm a year. I estimate about incremental EBITDA margins of 35-40% so higher labor utilization and operating leverage and I think growing the business 20% next few years to $120mm revenue run rate would not be a high hurdle rate to $15mm in EBITDA/$10mm in FCF (on today's $30mm EV)

- Infrastructure legislation: I hate using the term "free option" but thats what it is. If it passes, it certainly opens up a huge opportunity for EEI. But even now there is a ton of instructure work going on now as I mentioned earlier that the states are picking up the work that the federal government is lapsing. The CEO specifically called out the $8b Los Angeles County highway build out (http://www.latimes.com/local/california/la-me-high-desert-freeway-20180210-htmlstory.html) as an example. I would recommend perusing the Summit Materials (SUM) investor deck pages 6-7 on their outlook for state infrastructure spending (coming off a -6.8% in 2017 this is expected to grow 2-3% a year through 2021. http://investors.summit-materials.com/Cache/1001232372.PDF?O=PDF&T=&Y=&D=&FID=1001232372&iid=4293172 ... a fun factoid (per Barclays initiation on SUM as a reference) that if the the highway bills are longer than 2 years in length they tend to signifcantly outperform the growth in highway spending by shorter term bills especially in years 4 and 5.  We are hitting year 4 and 5 from the 2015 Obama signed highway transportation bill so this is a nice tailwind opportunity as well.

- Margin of Safety: Well I think the valuation speaks for itself. This is a reputable business thats been around for 40 years with a better cost base than in 2013-2014 when it was losing $1-2mm a year from its foray into loser foreign segments. I don't think its going to dissapear or go bankrupt. Its restructured and performed better during the recession in 2008 because of government work. I would say a run rate of current $6-7mm in EBITDA is pretty bottom ish but who knows? Can drop to $2-3mm. So at 4-5x EBITDA unlevered I think you're getting a rock bottom value. In 2015 Mill Road offered (verbally) "$13-$14" which was rejected.  They are now on the board and own 11% of the shares (though A shares that have 1/10th of vote of B shares). Their board members (Justin Jacobs and Michael El Hillow) are very reputable and have a history of major value creation, including in corporate governance, in their past holdings. So I think one of looking at it, is if everything goes wrong, these guys who offered to take the company private at $13-14 when it was losing money and had $0 (vs $5 per share) net cash on balance sheet and are still on the board, probably created a floor with their past offer. Another way to think about it is if you hold it for 3-5 years the company would generate an additional $4-$5 in cash/dividends in next 4 to 5 years so at $12.50 I guess your net downside is 20% if the actual business is worth nothing. I feel pretty good that it shouldn't come to this and at this price other than stock volatility due to illiqidity there is low risk of permanent capital impairment and the bigger risk in this story is dead money capital.

- Valuation/Upside: This is a fun discussion because this really could be anything. The closest pure play competitor, TetraTech, that has low single digit EBITDA growth (albeit w a better 11-12% EBITDA margin profile) and 1x EBITDA net debt, is trading at 11.5x FTM EBITDA. So say giving a conservative 8.5x on $7mm in EBITDA plus ~$20mm in cash gets you a market cap of $80mm or $18.50 or 50% upside. Thats not even the base case for us. The median TTM EV/EBITDA for the group (ITI, ENG, TRC (acquired), WLDN, NVEE, TTEK, HIL, WSC, CRAI) is 14.5x, the lowest is 9.5x (ex EEI).  Median TTM EBIT multiple is 17.6x, with 14.5x is the low. Assuming even the lows on EEI's depressed EBITDA still gets you a $20 price. Using medians gets you to closer to $30 or 150% upside. Again off a depressed EBITDA. As I said, I think if everything goes right and I dont see why it shouldn't, a $15mm EBITDA with an 11.5x TTEK multiple gets you to $45 or 250% upside.  I believe the previous write up mentioned that TRC was acquired for 13x.  My actual biggest fear is that Mill Road would offer low $20s in a year and management takes it instead of letting it play out. Personal opinion is that this should be an EASY strategic acqustion for any large E&C or TetraTech.

- Catalyst: You have to ask yourself this (and this is conjecture) but why would the founders (Frank, Silvestro, Strobel all late 70s/80) who control over 60% of the vote, allow Mill Road on the board despite a fight that Mill Road could not win on its own and allow them to cut the founders lucrative "board payments" of $1mm to $3mm? I believe they convinced the board that they could turn things around, get more share exposure and allow the founders to exit at the closer $40 to $50 valuations that I mentioned above. So I think we've already seen corporate governance progress but I think we'll see a lot more. Also as morbid as it is, the death of founders in the next few years is probably a catalyst as it could potentially begin to release their grip. 

Reasons to be concerned still

- Competitive environment ... last two years the pricing has gone down 3-4% on hourly rates. On the other hand EEI is invited to almost every big bidding opportunity and we spoke to an energy infrastructure client that spoke very highly of them. A lot of the wins/losses have to do with their partners which then sub out the environmental work to EEI (which is a separate issue of potentially being dependent on your partners business pipeline)

- Shift to government work versus a depressed private market has created some gross margin compression on mix.

- Internal control issues in Latin America have not allowed the company to certify itself as having working internal controls for the last two years. Retirement of CFO (though announced significantly prior) in the middle of fixing these issues could be considered red flaggish. Or maybe it was just time to drop the guy who was in charge of allowing this to happen.  The CEO told me that fixing these issues is priority number one right now, and they mostly have to do with the ERP systems in Latin America. Since EEI's LatAm business is mostly out of Brazil (Chile and Peru occassionally is well), a country that shares the coveted #79 (out of 168) corruption index ranking with Belarus, China and India, there is certainly a chance corruption has occured. I would say a big chunk of discount to peers has to do with this issue and fixing it in the next 12 months by the new board could be a significant catalyst.

- Management: I'll be honest, was not impressed with my convos with Gallagher. But not to say he wasn't competent, he's been a EEI lifer and knows the business well. He just didn't seem to think big or strategically and was more an operations guy. He also has very little skin in the game and makes a $300k-$400k cash, which is not a bad gig in Lancaster, NY if you can get it.  Luckily he's not on the board and does not have say in the bigger strategic decisions which are made by the original founders who own the A shares (over 1mm) or Mill Road 500k-ish and would not block a sale. I actually feel better that the actual shareholders are in charge.

 

 

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Increasing backlog

- Wall Street coverage/liqudiity event

- Transaction

    sort by    

    Description

    About a year ago there was a really good detailed write up on EEI by andreas947 (https://valueinvestorsclub.com/idea/ECOLOGY_AND_ENVIRONMENT_INC/140275) which is what got me interested (our fund owns about 1% of outstanding shares) so what I don't want to do is rehash the exact same thing without adding value. So what I'd like to do is do an executive summary and give you my take with some updates, some notes on my conversations with management and why now and this is more of add on discussion than a fresh idea pitch. 

    Elevator pitch: EEI is an environmental consultancy with a cash rich balance sheet (close to 40% of market cap), a strong dividend (~3%+ yield), trading at 15% Free Cash Flow yield (EV) on depressed cash flow thats bound for a breakout in next 12 to 24 months, with now TWO activist investor funds involved; with a longer term sale or ownership change catalyst on the horizon. The stock's margin of safety is backed by an implied standing offer of $13-$14 per share (when the company had $5 per share less cash on the balance sheet) by Mill Road Capital that is currently on the board and its low valuation with a potential 250% upside in the next 12-24 months.

    Why we like it?

    - Asset light consulting business with little fixed cost contracts. Unlike other E&Cs this is mostly a "C" and has ~85% of the business on Cost Plus (37%) and Time and Materials (47%). Its a simple to understand business.

    - Solid reputation: been around for 40 years, consistent partner with the big name E&Cs, always invited to bidding table on all new domestic projects

    - The dreaded "channel check" word but the reason we've held off investing for a year is because we were concerned about the state of the federal government business with Scott Pruit's EPA and how that could impact EEIs business. For context, of the $70mm in annual US revenues, half is government work ($35mm) and half that is federal government work ($17.5) and while not disclosing the actual numbers of how much the EPA is of that, it is not entirely dependent on EPA but diversified across other federal agencies and military (for example if you're building baracks or upgrading facilities on a base you need an environmental assesment. So part a) was figuring out that the EPA risk was not as big as feared. So b) does this business $10-12mm go away with the "I hate the EPA head of the EPA" and the answer is possible but not probable. Most of the actual issues have been delays in staffing in EPA who move these projects forward, not the cancellation of the projects (per our talk with a regional EPA sr staffer). Additionally there is always sort of permanent Superfund work and the Start IV contract. So I would say in a bear scenario maybe $5mm of that business is at risk. c) Apparently the states have been picking up the work that the federal government has not been doing so its just a shift from federal to state levels. So all those points and conversations asuaged our concern about this business. Per CEO, who is an EEI lifer, they tend to do better under Republican administrations than Democrat ones which makes sense given that Republicans tend to approve more energy projects...

    - ... which is the other side of the business ($35mm) is a lot of energy infrastructure work which has been pent up due to lower oil prices and Obama red tape. If you believe $70 oil releases more energy work as management does, this side of the business will do just fine. I am still doing more work on this and I'd like to get through more energy company earnings to hear their commentary on infrastructure CapEx before I put a definitive detailed answer here (under a due date for idea posting) but from everything I've gotten so far there is a lot of pent up demand which should bode well for EEI.

    - third leg of business is the $30mm breakeven LatAm business which is essentially Brazil which is coming off a brutal 2 year recession is finally showing signs of growth in 2018 with expectations for ~3% growth in 2019-2020. 

    "The Brazilian economy advanced 0.1 percent on quarter in the last three months of 2017, following an upwardly revised 0.2 percent expansion in the previous period and well below market expectations of a 0.4 percent rise. It is the lowest growth rate in four quarters after a 2-year recession in 2017. Considering full 2017, the economy expanded 1 percent, following a 3.5 percent contraction in both 2016 and 2015." - Trading Economics

    - Operating leverage: So you have a $100mm revenue business that generates $6-7mm in EBITDA (mostly US, with LatAm at breakeven) on a cost base of $38-$39mm now that Mill Road Capital is on the board and is making sure the 80 year old founders arent paying themselves "board bonuses" of $1mm to $3mm a year. I estimate about incremental EBITDA margins of 35-40% so higher labor utilization and operating leverage and I think growing the business 20% next few years to $120mm revenue run rate would not be a high hurdle rate to $15mm in EBITDA/$10mm in FCF (on today's $30mm EV)

    - Infrastructure legislation: I hate using the term "free option" but thats what it is. If it passes, it certainly opens up a huge opportunity for EEI. But even now there is a ton of instructure work going on now as I mentioned earlier that the states are picking up the work that the federal government is lapsing. The CEO specifically called out the $8b Los Angeles County highway build out (http://www.latimes.com/local/california/la-me-high-desert-freeway-20180210-htmlstory.html) as an example. I would recommend perusing the Summit Materials (SUM) investor deck pages 6-7 on their outlook for state infrastructure spending (coming off a -6.8% in 2017 this is expected to grow 2-3% a year through 2021. http://investors.summit-materials.com/Cache/1001232372.PDF?O=PDF&T=&Y=&D=&FID=1001232372&iid=4293172 ... a fun factoid (per Barclays initiation on SUM as a reference) that if the the highway bills are longer than 2 years in length they tend to signifcantly outperform the growth in highway spending by shorter term bills especially in years 4 and 5.  We are hitting year 4 and 5 from the 2015 Obama signed highway transportation bill so this is a nice tailwind opportunity as well.

    - Margin of Safety: Well I think the valuation speaks for itself. This is a reputable business thats been around for 40 years with a better cost base than in 2013-2014 when it was losing $1-2mm a year from its foray into loser foreign segments. I don't think its going to dissapear or go bankrupt. Its restructured and performed better during the recession in 2008 because of government work. I would say a run rate of current $6-7mm in EBITDA is pretty bottom ish but who knows? Can drop to $2-3mm. So at 4-5x EBITDA unlevered I think you're getting a rock bottom value. In 2015 Mill Road offered (verbally) "$13-$14" which was rejected.  They are now on the board and own 11% of the shares (though A shares that have 1/10th of vote of B shares). Their board members (Justin Jacobs and Michael El Hillow) are very reputable and have a history of major value creation, including in corporate governance, in their past holdings. So I think one of looking at it, is if everything goes wrong, these guys who offered to take the company private at $13-14 when it was losing money and had $0 (vs $5 per share) net cash on balance sheet and are still on the board, probably created a floor with their past offer. Another way to think about it is if you hold it for 3-5 years the company would generate an additional $4-$5 in cash/dividends in next 4 to 5 years so at $12.50 I guess your net downside is 20% if the actual business is worth nothing. I feel pretty good that it shouldn't come to this and at this price other than stock volatility due to illiqidity there is low risk of permanent capital impairment and the bigger risk in this story is dead money capital.

    - Valuation/Upside: This is a fun discussion because this really could be anything. The closest pure play competitor, TetraTech, that has low single digit EBITDA growth (albeit w a better 11-12% EBITDA margin profile) and 1x EBITDA net debt, is trading at 11.5x FTM EBITDA. So say giving a conservative 8.5x on $7mm in EBITDA plus ~$20mm in cash gets you a market cap of $80mm or $18.50 or 50% upside. Thats not even the base case for us. The median TTM EV/EBITDA for the group (ITI, ENG, TRC (acquired), WLDN, NVEE, TTEK, HIL, WSC, CRAI) is 14.5x, the lowest is 9.5x (ex EEI).  Median TTM EBIT multiple is 17.6x, with 14.5x is the low. Assuming even the lows on EEI's depressed EBITDA still gets you a $20 price. Using medians gets you to closer to $30 or 150% upside. Again off a depressed EBITDA. As I said, I think if everything goes right and I dont see why it shouldn't, a $15mm EBITDA with an 11.5x TTEK multiple gets you to $45 or 250% upside.  I believe the previous write up mentioned that TRC was acquired for 13x.  My actual biggest fear is that Mill Road would offer low $20s in a year and management takes it instead of letting it play out. Personal opinion is that this should be an EASY strategic acqustion for any large E&C or TetraTech.

    - Catalyst: You have to ask yourself this (and this is conjecture) but why would the founders (Frank, Silvestro, Strobel all late 70s/80) who control over 60% of the vote, allow Mill Road on the board despite a fight that Mill Road could not win on its own and allow them to cut the founders lucrative "board payments" of $1mm to $3mm? I believe they convinced the board that they could turn things around, get more share exposure and allow the founders to exit at the closer $40 to $50 valuations that I mentioned above. So I think we've already seen corporate governance progress but I think we'll see a lot more. Also as morbid as it is, the death of founders in the next few years is probably a catalyst as it could potentially begin to release their grip. 

    Reasons to be concerned still

    - Competitive environment ... last two years the pricing has gone down 3-4% on hourly rates. On the other hand EEI is invited to almost every big bidding opportunity and we spoke to an energy infrastructure client that spoke very highly of them. A lot of the wins/losses have to do with their partners which then sub out the environmental work to EEI (which is a separate issue of potentially being dependent on your partners business pipeline)

    - Shift to government work versus a depressed private market has created some gross margin compression on mix.

    - Internal control issues in Latin America have not allowed the company to certify itself as having working internal controls for the last two years. Retirement of CFO (though announced significantly prior) in the middle of fixing these issues could be considered red flaggish. Or maybe it was just time to drop the guy who was in charge of allowing this to happen.  The CEO told me that fixing these issues is priority number one right now, and they mostly have to do with the ERP systems in Latin America. Since EEI's LatAm business is mostly out of Brazil (Chile and Peru occassionally is well), a country that shares the coveted #79 (out of 168) corruption index ranking with Belarus, China and India, there is certainly a chance corruption has occured. I would say a big chunk of discount to peers has to do with this issue and fixing it in the next 12 months by the new board could be a significant catalyst.

    - Management: I'll be honest, was not impressed with my convos with Gallagher. But not to say he wasn't competent, he's been a EEI lifer and knows the business well. He just didn't seem to think big or strategically and was more an operations guy. He also has very little skin in the game and makes a $300k-$400k cash, which is not a bad gig in Lancaster, NY if you can get it.  Luckily he's not on the board and does not have say in the bigger strategic decisions which are made by the original founders who own the A shares (over 1mm) or Mill Road 500k-ish and would not block a sale. I actually feel better that the actual shareholders are in charge.

     

     

     

     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    - Increasing backlog

    - Wall Street coverage/liqudiity event

    - Transaction

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