MEADOW VALLEY CORP MVCO W
January 30, 2009 - 3:56pm EST by
roc924
2009 2010
Price: 6.25 EPS $1.20 $1.20
Shares Out. (in M): 5 P/E 5.0x 5.0x
Market Cap (in $M): 32 P/FCF 2.0x 4.0x
Net Debt (in $M): -32 EBIT 8 8
TEV ($): 0 TEV/EBIT 0.0x 0.0x

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Description

Summary

  1. MVCO has a construction services business that builds roads and bridges for the states and municipalities of Arizona and New Mexico.
  2. Under a proposed deal with a private equity firm, management wants to buy your shares at $11.25 by leveraging up its current equity stake.
  3. MVCO has about $6 in cash net of debt and $1 in investments (RMX).
  4. Construction services should benefit from infrastructure stimulus spending.
  5. Construction services generated $3.50 per share in free cash flow (ex a onetime gain) using only about $3.30 in net assets to do it (i.e. >100% cash RONOA) in the last 12 months ended Sep08. Returns on incremental capital should be at least as strong.
  6. Construction services only reported $1.50 in TTM net income versus $4.17 in TTM free cash flow. These large negative accruals are likely to reverse in the next year or two, providing a nice tailwind to earnings.

Business Description
MVCO ($6.25) is a holding company with three subsidiaries: 1) a wholly owned construction services company whose backlog is 90% public construction projects (roads, bridges, etc.), 2) Ready Mix (ticker=RMX), of which MVCO owns 69% and 3) a wholly owned but financially insignificant materials testing company. MVCO consolidates RMX. Backing out the consolidation of RMX, you'll find construction services is dirt cheap. It has over $6 per share of cash and generated free cash flow of $3.50 per share in the last twelve months excluding a one-time gain ($4.15 including it).


The construction services subsidiary operates in southern Nevada and Arizona. Through this segment, the Company performs heavy civil construction such as the construction of bridges and overpasses, channels, roadways, highways and airport runways (90%+ public, rest private). The two largest customers are the Arizona Department of Transportation (25% of 2007 revenue) and Clark County, Nevada (21%).
The construction materials segment is publically traded (ticker=RMX), MVCO owns 69% of it, and accounts its ownership interest using the consolidation method. RMX manufactures and distributes ready-mix concrete and sand and gravel products in the Las Vegas, Nevada and Phoenix, Arizona markets.


Investment Case and Valuation:
Insight equity offered to buy MVCO at $11.25 last year. The deal is still pending. Under the deal terms management committed to increase by 30-60% their substantial equity ownership stake at $11.25 per share through the leverage inherent in the deal. In other words, management thinks the stock is cheap at almost 80% higher valuations. Since management is leveraging up their equity interest in the deal, they have incentive for the deal price to be as low as possible.
The stock is down primarily because the private equity firm that agreed to buy the company with management at $11.25 is trying to renegotiate or back out of the deal (see press release dated December 1, 2008). The odds seem low the current deal goes through, but the odds are high management tries to take the company private another way and you just have to wait longer. Regardless, without a deal the company is compelling:
1) Very high return on net assets
2) Very cheap valuation
3) Understated earnings power
4) A potential tailwind from infrastructure stimulus spending
5) Management that wanted to leverage up their equity at almost 80% higher valuations and will likely find another way to take the company private.

1) Very high return on net assets
The construction services business has a 30-50%+ return on net operating assets assuming the company needs $25m in cash for ongoing operations, primarily related to bonding requirements. RONOA on incremental dollars invested in the business is probably higher. I'd be happy to detail the calculation in the message section. Note the consolidation of the construction materials business masks the high return on net assets generated by the construction services business. The cash flow statement suggests that recent operating income is understated; cash RONOA has been >100%.

2) Very cheap valuation
Trades at 4x average free cash flow from the past five years and about 2x TTM cash flow. Backing out my estimate of excess cash (the construction services business needs cash for bonding requirements), those figures are about 3.3x and 1.4x respectively. The construction services business generated free cash flow of $1.50 per share on average per year in the last five years and $3.50 in the TTM period excluding a onetime gain.
Has over $6 per share of net cash, excluding RMX, which separately could be worth around $1 per MVCO share.
Assuming RMX is worth zero, the price to sales multiple of the construction services business is 0.2x versus 0.5x for Granite Construction (GVA). I'd prefer to use enterprise value to sales, but MVCO's enterprise value is close to zero. Again assuming RMX is worth zero, construction services has a trailing P/E of 4x versus 13x for GVA. This despite the understatement of MVCO's earnings and MVCO has 100% of its market value in cash versus a relatively insignificant amount for GVA.
The figures above exclude the company's ownership of 2.6m shares of RMX (69% ownership). MVCO consolidates RMX. RMX, for which MVCO guarantees some of its debt, has tangible book value of $7.25 per RMX share or $3.70 per MVCO share. RMX trades at $1.40 today, which is about $0.70 per MVCO share. If one assumes RMX's cash is worth 100%, AR 80%, inventory and PP&E 50% and liabilities 100% and assume $4m in liquidation costs/cash burn (vs $27m of equity and $1m cash burn in 3Q08) then RMX is worth $1.88 per share or $1.30 per MVCO share.

3) Understated earnings power
The company's earnings power is understated. Free cash flow in the last twelve months in the construction services business was $4.17 versus net income of $1.50 in the trailing 12months ended September 2008. These negative accruals will eventually have to be reversed, which will provide a powerful earnings tailwind. It is interesting to juxtapose these large negative accruals with management's incentives under the deal terms (i.e. management and Insight both had an incentive to price the deal at the lowest possible price).

4) Favorable sector
There is a potential tailwind from infrastructure stimulus spending. Or at least construction of public works projects seems unlikely to slow with the current administration, even in deficit states like Nevada or Arizona.

5) Management that wants to leverage up their equity at almost 80% higher valuations.
Under the deal terms management will leverage up their substantial equity investment in the company at $11.25 per share. Management's (Larson's and Nelson's) interest in the newly private company would increase by 30-60% (depending on how many shares management elects to sell to cover taxes from option exercises) at a price 80% higher than today's because of the leverage in the deal. In other words, management thinks the stock is cheap at $11.25.

Catalysts
Deal goes through, or management finds another way to take the company private.
Accruals reverse (100% chance that they reverse eventually), providing a large boost to earnings.

Large Shareholders
Brad Larson, Director, President and CEO and Kenneth Nelson, Director, VP and Chief Administration Officer, each own 2.8% of the company.
5% owners per December 2008 14A:
8% North Atlantic Value LLP
7% Tontine Capital Partners, LP
6% Hoak Public Equities, LP
7% Carpe Diem Capital Management LLC; In a recent 13D, said won't accept less than 11.25.
7% Lord, Abbett & Co. LLC
Pennsylvania Avenue Funds is suing, alleging "the Company and its directors breached their fiduciary duties for failure to maximize shareholder value in the negotiation of the merger".

Risks
The odds of the current deal happening appear low, and if it is rescinded, the stock is likely to go down in the near term.
Cost overruns on contracts. The company had cost overruns when it expanded into Utah and New Mexico earlier this decade. The company subsequently exited Utah and New Mexico and now concentrates on its core Nevada and Arizona markets where it is familiar with the municipal officials and process.
Competition in construction services is increasing.
High customer concentration.
Project cancellations or push-outs. The company's business is in AZ and NV, states with large deficits. Probably more than offsetting this factor will be infrastructure stimulus spending.


Catalyst

Deal goes through, or management finds another way to take the company private.
Accruals reverse (100% chance that they reverse eventually), providing a large boost to earnings.

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