Description

Recommendation

Buy LAYN convertible bonds.  The issue sizes are small and the paper is relatively illiquid but if you can find them, I believe that both LAYN convertible bonds offer excellent risk adjusted returns.  The high yield market is on edge at the moment and some of this type of off-the-run paper could be put up for sale, perhaps a lot lower in price.  The recently issued 8.0% second lien converts sit at the very top of the capital structure and currently trade close to par.  While the yield is not overly juicy, the asset coverage on the bond is exceptional and investors can get a cheap/free call option (via its $11.70/sh conversion price) on the Company’s turnaround.  The 4.25% unsecured converts in the mid to high 70s offer a mid single digit current yield and a YTM in the low teens.  I believe this yield is attractive for a relatively short dated paper that creates the assets at less than $100mm. 

The equity with a market cap of $160mm is interesting but given what has happened to the small/midcap universe in recent months, I think there’s probably even better situations elsewhere.  Having said that, there’s quite a bit of operating leverage in the assets here and if management continues to execute like it has been recently, there could be plenty of upside in the stock 18 – 24 months out when EBITDA could potentially exceed $45mm.  Nobody, including myself, is expecting much of anything from its problem segments, which are essentially low priced options for equity holders.  It’s worth noting that insiders appear to be bullish on the Company’s prospects having recently purchased over $1mm worth of stock at an average stock price of $8.32, ~11% higher than current levels.

Company Overview

LAYN is a global water management, construction and drilling company providing solutions for various water, mineral and energy challenges.  For a smallish enterprise, it operates in quite a few segments and many would argue that they are in too many different businesses and perhaps the lack of focus is what got them into trouble in the past.  Currently, the Company’s segments include Water Resources, Inliner, Heavy Civil, Geoconstruction, Mineral Services and Energy Services.  Note that the Geoconstruction segment is currently under an LOI and will be divested shortly and so there will be one less segment to worry about.  The two segments that matter, in a positive way, with regards to the investment thesis are Water Resources and Inliner.  On the flip side, the key segment that could negatively impact the investment thesis is Heavy Civil.  Mineral Services and Energy Services segments appear to be neutral to the thesis given what we know about them today.

A very quick and basic overview of the go-forward segments:

Water Resources

While the Company started off as a water well driller, it now provides solutions for every aspect of the water infrastructure system, from discovery to disposal.  This includes water supply system development and technology solutions, including hydrologic design and construction, source of supply exploration, well and intake construction and well and pump rehabilitation.  The Company also engineers and constructs water and wastewater treatment systems that decontaminate regulated and nuisance and volatile compounds. Finally, it engineers and installs disposal wells.  The initial drilling of wells puts the Company in a position to win follow-up rehabilitation business, which generates higher margins and is periodically required during the life of a well, as groundwater may contain contaminants and screen openings may become blocked, reducing the capacity and productivity of the well.

Inliner

As the second largest cured-in-place pipe lining company in the U.S., this segment offers a wide range of process, sanitary and storm water rehabilitation solutions to municipalities and industrial businesses dealing with aging infrastructure needs.  The Company’s technology rehabilitates aging and deteriorated infrastructure and provides structural rebuilding as well as infiltration and inflow reduction.  Because the product is trenchless, it reduces rehabilitation costs, minimizes environmental impact and reduces or eliminates surface and social disruption.  The Company has installed more than 19mm feet of cured-in-place pipe lining throughout the U.S.

Heavy Civil

This segment oversees the design and construction of water and wastewater treatment plants and pipeline installation.  Additionally, the Company builds radial collector wells, surface water intakes, pumping stations, hard rock tunnels and marine construction services. Beyond water solutions, the Company designs and constructs biogas facilities for the purpose of generating and capturing methane gas.

Mineral Services

This segment serves mining companies, mostly gold and copper miners, who retain the Company to extract rock and soil samples from their sites that they analyze for mineral content and grade before investing heavily in development to extract these minerals.  The Company conducts both greenfield drilling to determine if there is a minable mineral deposit on the site and also brownfield drilling to assess whether it would be economical to mine and to assist in mapping the mine layout.  This segment operates throughout Africa, North America and Australia but given the global commodity slowdown, the Company has been shifting assets to focus on the Americas.

Energy Services

This segment focuses on providing water management solutions to E&P clients who are increasingly dealing with water related challenges. The water demands of the energy industry are substantial and the Company will look to capitalize on this growth by managing every phase of the water cycle for conventional and unconventional oil and gas companies. The Company provides hydrogeological assessments, feasibility evaluations, potential capacity determinations, which lead to appropriate well designs for developing local groundwater supplies.  Additionally, it provides transfer services that include various no-leak solutions for surface and subsurface transfer, pit-to-pit transfers, surface transfers, fluids infrastructure design and construction and other high-volume fluids handling capabilities.  Moreover, the Company provides construction services for retaining ponds for frac water, flowback fluids and produced water.

Capitalization

The Company has three debt instruments in its cap structure.  There’s a $120mm ABL facility that is currently undrawn and has $33mm in LCs drawn against it; as of Q1, the borrowing base was $94.7mm resulting in excess availability of $61.7mm.  In March 2015, the Company issued $100mm of 8.0% convertible notes.  Approximately half of this amount was issued at par to holders who held $55.5mm of its existing 4.25% convertible notes pursuant to an exchange transaction.  As a result, the Company raised ~$45mm of new cash from the offering of which $18.2mm was used to pay off the balance on the ABL facility. The Company had total debt of $169.5mm and cash of $56.6mm at the end of Q1; total liquidity was a very healthy $118.3mm.

In May 2015, LAYN agreed to sell its Geoconstruction business for $34.5mm plus the value of its working capital at closing, currently estimated to be $5.0mm.  This sale is expected to close in Q2 and will increase the pro forma cash and liquidity to $96.1mm and $157.8mm, respectively.

The 4.25s are senior unsecured obligations of LAYN. They mature on November 15, 2018.  The conversion rate is 43.6072 shares of common stock per $1,000 principal amount (equivalent to a conversion price of $22.93 per share of common stock). The 8s are senior secured obligations of LAYN.  They are secured by a lien on substantially all of the assets of LAYN and the subsidiary guarantors. These liens on the assets are junior in priority to the liens under the ABL facility.  The bonds will mature on May 1, 2019, however, if the Company has not dealt with the 4.25s by August 15, 2018, the maturity on the 8s will accelerate to August 15, 2018.  The conversion rate is 85.4701 shares of common stock per $1,000 principal amount (equivalent to an conversion price of $11.70 per share of common stock). 

Summary Financials

Until very recently, LAYN fundamentals have deteriorated significantly since FY12.  Total revenues are down by a quarter and the Company operated on an EBITDA breakeven basis in FY15, down from $95mm in FY12.  The Company has burnt through almost $100mm in cash over the last three years and leverage has increased by $78mm.  With a new management team in place with a well thought out turnaround plan, business has somewhat stabilized over the last several quarters but the Company is still expected to incur a cash burn over the next several quarters.

So, why bother with a Company that is burning cash and barely EBITDA positive?  Well because the consolidated financials do not reflect the intrinsic value of several businesses within LAYN that are performing extremely well and have solid growth potential going forward.  The Water Resources and Inliner businesses have been growing the top line nicely and produce significant EBITDA for the Company.  Water Resources has experienced growth recently primarily as a result of projects in the western U.S. where inadequate water infrastructure combined with lingering drought conditions have resulted in additional opportunities to provide water management services, particularly in the agribusiness market.  Inliner continues its consistent growth as demand for sewer rehabilitation remains high given the deteriorating urban infrastructure, rising population, deteriorating water quality and infrastructure that supplies our water. Additionally, federal and state agencies are forcing municipalities and industry to address infiltration of groundwater into damaged or leaking sewer lines, enforcing stricter regulation and new technology provided by the likes of Inliner.  In the current fiscal year, these two segments should contribute over $55mm in combined EBITDA (pre corporate overhead) for the Company and I expect this to grow over time given market dynamics for water solutions and infrastructure rehabilitation. 

Unfortunately, the other three segments don’t contribute much towards the Company’s profitability and in fact are burning cash.  Mineral Services was at one point the Company’s largest and most profitable business but given what’s been happening to the copper and gold mining industries these days, this segment is a shell of its former self.  It is losing money today and I’m assuming that it will not be contributing much to LAYN’s profitability in the near-term.  Energy Services is a new business and appears to have good growth prospects given the heavy/complex water requirements for E&P exploration.  However, this segment, while growing fast, is also not a profit contributor and I’m assuming that this will remain the case over the next couple of years. 

And that brings us to the disaster that is Heavy Civil.  The Company can’t blame the market for this segment’s troubles like it can for Mineral Services – all the problems here are self-inflicted.  Cost overruns and under bidding on projects has resulted in massive losses – I estimate that this segment has burnt through $60 – $70mm in cash over the last three years.  While most of the pain with regards to these troubled legacy contracts has already been taken, management claims that approximately $32mm of the current backlog represents contracts that are in a loss position.  In my projections, I assume that this segment will lose an additional $15mm over the next couple of years.

In terms of free cash flow, I expect the Company to burn close to $20mm over the next year but should be cash flow positive starting next year.  Capex was slashed last year given liquidity concerns but with that no longer an issue, I expect the Company will increase spending once again to fund growth in the Water Resources and Inliner businesses. 

Valuation / Recovery Analysis

Obviously, it makes the most sense to value the segments separately given how the consolidated financials mask the value in the profitable businesses.  The Water Resources and Inliner segments should generate approximately $60mm in EBITDA by next year.  This figure does not include the corporate overhead nut which has been trending in the $40 – 45mm per year range recently.  This level of overhead is unacceptably high and will decline substantially over the next two years.  Management is confident that it can be cut to $35mm this fiscal year and I’m estimating that it will decline to $30mm by the end of next year.  While I don’t have any deep insight into how to best allocate the overhead to the various segments, I have assigned $10mm each to Water Resources and Inliner for the purposes of my valuation analysis.  This gets me to a fully loaded EBITDA of approximately $40mm and a valuation of $245mm for these two businesses.  A quick comment on the overhead: management seems to suggest that most or all of this unallocated overhead is public company related expenses and would not need to travel to a buyer in a sale transaction.  While there might be some truth to this, it makes sense to be conservative and bake in additional overhead to the segment level profitability.  I believe a 6.0x multiple is conservative and that these assets would likely fetch more than this amount if they were put up for sale.  

While the other three segments are unprofitable and likely have little to no going concern value, I doubt that they’re a complete writeoff.  There should be assets, particularly at Heavy Civil and Mineral Services, which could be monetized in a liquidation scenario.  The bulk of this value would be in the equipment (machines, rigs, etc.) and while there’s not enough disclosure to get to an accurate liquidation value, I’ve made a few assumptions that get me to an approximate $50mm value.  I start with the assets at the segment level and assume that 65% of this is working capital related and the balance would be hard assets.  The working capital assets would offset the liabilities and the residual hard assets could then be sold in a liquidation.  Since the hard asset book value represents heavily depreciated figures on the balance sheet, I felt that a 50% realization assumption was reasonable.

Putting all this together and adding the cash on the books, the cash from the Geoconstruction sale, I get to a total distributable value of $370mm.  This includes a value leakage assumption of $20mm for additional cash burn over the course of this year.  I’ve assumed zero value for additional assets such as NOLs and interests in affiliates within the Mineral Services segment and there might be pockets of additional value on the balance sheet.  For example, the Company expects to sell $5 – $10mm in noncore real estate over the next year as part of its turnaround plan.

Value coverage for both the converts is exceptional and there should be significant residual value for equity holders, which would increase substantially if the Company keeps executing. 

Risks to Consider

·      All of LAYN’s businesses would struggle in a recessionary environment and if the U.S. is heading in that direction, the turnaround will fail and cash burn will continue and perhaps even worsen

·      Given the nature of their businesses, the Company has to compete for contracts with fixed-prices.  The Company has gotten into trouble by underbidding for work causing massive losses in the Heavy Civil segment.  There’s really no solution for this and investors are at the mercy of the new management team being up to the task and pricing contracts appropriately and walking away from questionable work

·      Within Mineral Services, the Company relies on JVs with partners to fulfill contracts.  Should the JV partners not live up to their obligations, the Company may have to come out of pocket to bridge any funding gap

·      The bond indentures are not strong in that they allow the Company to keep the first $50mm in asset sale proceeds even if they're not reinvested back into the business.  This basically provides management with a blank check without an expiration date to use the proceeds from the Geoconstruction sale for whatever purpose they deem appropriate.  There is always the risk that they use the money to buy another business which may destroy value for the bond and stockholders

Catalyst

- Getting to cash flow breakeven over the next 6 - 8 quarters

- Additional non-core asset sales and/or complete exits from unprofitable segments

- Value accretive use of excess cash on balance sheet