Description

HIL is a Pennsylvania based construction consulting firm with over 100 offices globally. It provides program management, project management, construction management, construction claims and other consulting services primarily to the buildings, transportation, environmental, energy and industrial markets. HIL operates through two reporting segments: the Project Management Group (74.2% rev) and the Construction Claims Group (25.8% rev).

The Project Management Group provides fee-based construction management services, managing all phases of the construction process from concept through completion. They do not assume project completion risk and their fee-based model eliminates many of the risks typically associated with providing "at risk" construction services.

The Construction Claims Group advises clients in order to assist them in preventing or resolving claims and disputes based upon schedule delays, cost overruns and other problems on major construction projects worldwide.

Here is how HIL’s revenues break down

by geographic region:

by client type:

HIL trades at 6.8x for 2015 ev/ebitda and 5.1x for 2016, vs the 8.5-9x range for its closest peers (WSP Global, Tetra Tech, Stantec, WS Atkins). Until the unsolicited bid from DC Capital earlier in May (more on that later) it was trading even lower, at 5x ebitda, (<$4). The reasons for the depressed multiple can be traced to 1) poor profitability/historical leverage issues, 2) [mis]-perceived geopolitical risks and 3) entrenched management.

1.     Profitability/Leverage issues

Most recently it reported 5.5% ebitda margin. That alone is enough to keep the multiples where they are vs its peers who report margins in 10% range. Several factors contributed to this.

a) Operational missteps. There were a few as the industry recovered from the 2008 crash, but the most material were initial failures to recover payments in Iraq and Lybia. This forced the company to take out expensive loans, with high interest payments eating further into profits, and it appeared to be in a precarious situation. In the last year or so HIL recovered the payments, paid back the debt, took on better loans and issued equity, taking the distress concerns off the table. In addition to margins, once the market started to come back, HIL failed to deliver on operational leverage and continued making acquisitions neglecting profitability, which leads us to

b) Bloated headcount. For the past 5 years HIL has been adding about 450 new employees per year, nearly doubling its staff from 2,355 in 2010 to 4,550 now. Of those 4,550 a few employees particularly stand out:

c) Excessive executive compensation. To illustrate how aggressively the management paid itself here’s exec comp for previous 3 years:

Looking at 2013 as the year where their free cash flow was the highest in the past 5 years ($13.8m), the total cash compensation for that year for the top executives was $4.8m. That’s more than 25% of the pre-compensation FCF.

2.     Market’s overly anxious perception of HIL’s geopolitical risks

HIL’s Mid East exposure, while a major contributor to the company’s growth, is also a source of understandable discomfort for investors concerned with geopolitical risks. However, post HIL’s exit from Lybia after the revolution there, its remaining operations are based in the most stable countries in the region: Saudi Arabia, UAE, Qatar and Oman, all with stable political history, healthy budgets, and strong desire for economic/political stability.  The latter has been secured in part by the governments’ drive to stimulate economic activity.

3.     Management entrenchment

The current CEO David Richter is the son of the company’s founder, and the Richter family owns ~30% of the stock. The board is staggered and has recently enacted a poison pill

Why is this name attractive now?

Several factors combine for an attractive risk-reward for this under-followed company:

1.     Attractive valuation

While the reasons for the low multiples were discussed above, it’s worth noting HIL’s FCF yield is at the upper end among its peers (6%+) and is accompanied by higher organic revenue growth (8-9% vs low single digits for the peers).

Further, HIL doesn’t really have an easily identifiable peer group in the US. The limited analyst coverage we have here compares it to engineering/construction firms (URS, Jacobs Engineering, etc) which face very different market dynamics and risks. A more appropriate group would be international project management firms such as above mentioned Stantec, WSP Global, Tetra Tech etc., all of which trade at much higher multiples

2.     Implementation of the cost cutting program

In their past quarterly calls management discussed a cost optimization program they planned to initiate this year. No details were discussed, and until the most recent call it was assumed that an overhead structure review process would take until the end of 2Q15. On the May 5^th call they said the plan should be implemented by the end of 2Q15, and that the targeted annual savings would be $25 million. Most of this amount is achievable as it’s likely to come from headcount reductions. They guided to 8-10% ebitda margin for 2015, which we find aggressive given they are now delivering about 5.5%. But if they achieve anything close to 7.5% in the next Q and 8%-10% for the quarter after that, the market is likely to reward them with a nice multiple expansion. For reference, Stantec delivers 10% margin and trades at 8.5x ev/Ebitda

3.     Exposure to robust growth markets

This comes from HIL’s relatively deeper exposure to emerging markets and specifically the Middle East, a generally higher-growth region with long and extensive new projects, yet relatively low homegrown experience in managing large developments. The region is in the early phases of non-energy infrastructure development. The overarching transition towards the post-oil&gas economics will continue to increase infrastructure demand in the long term. But in the more observable future preparations for events such as Expo 2020 in UAE and possible FIFA world cup in 2022 in Qatar will provide for additional opportunities.

4.     Emerging positive regulatory and geopolitical changes

Iran:

It is difficult to predict the outcome of the economic sanctions lift negotiations, but if it were to happen, it could be a very positive development for HIL. Directly, Iranian’s years of isolation, has likely created an urgent need for various infrastructure projects to accommodate demands of its growing young population. Indirectly, neighboring countries, especially trading hubs such as UAE where HIL has a strong presence, are also likely to see an uptick in projects facilitating new trade/travel avenues. While it’s not clear whether the sanctions lift would ultimately result in increased stability in the region, it seems introduction of a new massive trading partner should create opportunities for a nimble, experienced player with presence in the region, such as HIL. It appears HIL has been quietly positioning itself for Iranian market opportunity judging from hiring ads listing Persian language proficiency as a must.

Cuba:

Similarly, recent advances in US-Cuban relations are likely to offer opportunities for HIL to help address the enormous lag Cuba has accumulated over its years of isolation. HIL’s strong presence in Latin America positions it well to take advantage of any upcoming opportunities

5.     Recent bid from an experienced and determined PE firm

On May 4^th DC Capital made public its letter to the HIL’s management offering to pay “not less than $5.50” to take the company private. DC Capital has been active in the space and as recently as 2013 took another construction firm, Michael Baker Corp (BKR), private. That transaction also started with an unsolicited approach by DC. That, and the prodding by an activist shareholder Cadence, led to a formal sale process where DC ended up the ultimate buyer despite the presence of multiple strategic acquirers. Similarly to the HIL situation DC encountered highly reluctant sellers and employee resistance. Insiders owned about 15-20% of the company. Chariman/founder of the company did not want to sell, particularly to a PE firm. After DC’s approach he fired the CEO to demonstrate the company was capable of reforming itself.  Despite all that, 8 months later DC bought the company raising the bid from the original $24.25 to $40.5. In another 6 months after series of staff reductions and other cost cutting measures they almost doubled the ebitda of the acquired company.

In their letter to HIL DC referenced 2 concerns: disproportionate exposure to Mid East, and the ”lack of sufficient fiscal discipline to maximize shareholder value“  In further discussions they referred to the latter as "expense waste and excessive management comp.”

It sounds like they intend to repeat their BKR blueprint of cutting costs by reducing headcount.

Interestingly, one of Crescendo’s officers, Arnaud Ajdler, at some point was a director at HIL. After leaving Crescendo he started Engine Capital and while I don’t see them on the shareholder list now, last year he was describing HIL as an attractive investment at the Value Investing Congress.

6.     Presence of an activist investor

On May 14 Bulldog Investors disclosed a 5% position accumulated since the end of 2014. Most of the shares were bought in the last 2 months leading up to the DC offer. They then continued buying after the offer became public and it looks like they are eager to see the company sold. They are trying to put 2 directors on the company’s board and to get rid of the poison pill, both to be put on the June 9 shareholder meeting agenda. The company rebuffed this by claiming Bulldog did not follow the proper procedural and timing protocol. Bulldog is now trying to resolve this in court. Since Bulldog has been sloppy in similar situations in the past, we think the company has a good chance of fending them off for the time being. But nevertheless the June meeting may become a catalyst.

While the last 2 items above already began to improve valuation (the stock went from $4 to $5.47 in the recent month with the 2015 ev/ebitda multiple going from 5x to 6.8x), HIL still looks very attractive to us.

As is often the case with similar company-in-play situations, we find that the recent events established a floor and a very attractive risk-reward for the stock: if the cost optimization is successful, the market is likely to reward HIL with a higher multiple. Going to 8.5x ev/ebtida would translate into $7.5 It will also justify a demand for a higher price tag in any M&A scenario. On the other hand, if we end up with another unprofitable quarter, the case for the sale of the company will be further validated, and the takeover scenario becomes more realistic.

Risks:

If the company fails to deliver on the margin expansion, despite the predictable pressure from other holders to sit down w/ DC, it will still be an uphill battle for them. HIL’s board is staggered, so in the worst case waiting to install new directors may be necessary in order to remove the pill. That is unless DC is prepared to fight the pill in the court as we’ve seen done in other cases.

DC certainly demonstrated its patience and determination in the past transactions and we know DC’s offer was not a spontaneous one-off. We now know DC has been pursuing HIL for the past year and a half. They’ve also shown their ability to encourage additional shareholder pressure on the management and we anticipate further activist attention to this situation. With the insiders controlling 30% of shares it’s not an easy task, but with enough shareholder support DC could call a special meeting. HIL’s bylaws state: “… the holders of a majority in amount of our capital … may call a special meeting of stockholders.”

DC is clearly aware of the obstacles in its way and said they “intend to be patient" as they are gaining more support from other holder.

The other risk has to do with the Middle Eastern origin of 50% of HIL’s revenues. While for the above mentioned reasons we find it unlikely, we cannot discount entirely a possibility of hostilities and instability disrupting the region.

Disclosure:

I do not hold a position of employment, directorship, or consultancy with the issuer.

I and/or others I advise hold a material investment in the issuer's securities.

This investment may change at any time.

Catalyst

1.     DC capital activity

2.     Activist pressure

3.     June shareholder meeting, though we believe Bulldog is unlikely to succeed this time around

4.     Cost cutting bearing fruit in margin expansion followed by improved multiple

5.     Cost cutting NOT bearing fruit exposing the company to stronger MA pressure

6.     Opening of Cuba

7.     Iran sanctions lift