|Shares Out. (in M):||30||P/E||0||0|
|Market Cap (in $M):||402||P/FCF||0||0|
|Net Debt (in $M):||353||EBIT||0||0|
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Team (TISI) is the largest provider of inspection and mechanical services to refineries, petrochemical plants, pipelines and power facilities. TISI’s technicians operate out of 220 locations, predominately in North America (84% of revenue). 90% of revenue is billed as time and materials.
TISI reports three segments:
Inspection and assessment: 48% of FY’16 revenues. Technicians perform a variety of methods of non-destructive testing (NDT) on mid/downstream equipment and infrastructure. This segment also contains a meaningful heat-treating business. Revenues are ~40% on-site technicians (full time), ~30% emergency call out services, and ~30% project-based/turnaround work.
Mechanical Services: 47% of FY’16 revenues. Technicians perform a variety of maintenance services during both an on-stream (plant running) and turnaround (plant shut down) environment. Services include leak repair, emissions control, hot tapping, field machining, technical bolting, valve repair, field welding, and heat exchanger services. Revenues are ~10% on-site technicians (full time), ~45% emergency call out services, and ~45% project-based/turnaround work.
Quest Integrity: 5% of FY’16 revenues. Proprietary in-line inspection technology (smart pigs) and service offering.
Team had a long history of profitable growth under prior CEO Philip Hawk, who was CEO from 1998-2014. TISI stock was in the mid-$40s and the company was viewed as an asset-light cash-machine focused on a growing, stable end-market. In late 2014, Ted Owen (who had been CFO) took over as CEO. Unfortunately, the results were far less satisfactory under his watch (as EBITDA declined from $91mm to $58mm despite spending $590mm on acquisitions).
Ted’s first mistake was levering up to buy Qualspec (an on-site NDT business) for $255mm in mid-‘15. While the asset was nicely complementary to TISI’s existing NDT offering and added $24mm of EBITDA (to a base of $91), the timing was poor (Ted basically top-ticked the market). His second mistake was acquiring Furmanite, a mechanical services competitor with $38 of PF EBITDA, for $335mm in November ‘15 (closed in mid-‘16). The deal was billed as deleveraging as it was a stock deal, however, in hindsight it was anything but. Both of these deals were done while Team was in the midst of rolling out a new ERP system, further complicating what would have already been a difficult task.
As the end market for Team’s services weakened, Ted remained convinced that the recovery was just around the corner and was slow to right-size Team’s cost structure. As the results deteriorated further, TISI began brushing up against its bank covenants yet management was slow to react (if you read the calls sequentially, you can observe Ted going through the five stages of grief). In November ’16, TISI announced a $150mm ATM (at-the-money) offering in order to accelerate their debt paydown. After the announcement, the stock came under a little pressure (understandably – ATMs are often used by MLPs and shady shipping companies) but still remained in the low-to-mid $30s for several months. Yet on the Q4 call (3/8/17), management indicated they had only sold $6mm of equity. Apparently, Ted had been waiting for a better price. When pressed on that same call whether management would be willing to sell additional equity at the new (lower) levels (high $20’s), Ted boxed himself into a corner and explicitly said “No.”
I believe at this point he decided to swing for the fences. He continued to staff aggressively gambling on a sharp pickup in demand. Meanwhile, the ERP implementation was “taking twice as long and costing twice as much” (Ted’s words) and the integration of Furmanite was proving challenging. Unfortunately, the market for TISI’s services remained soft, leading to continued margin pressure (exacerbated by extremely poor labor utilization rates). After two more lousy quarters (and a couple more covenant waivers), Team ran out of time and was forced to come to the market with a convertible debt offering. This was the nail in the coffin for many long-time shareholders and the stock was obliterated.
On 9/12/17 Engine Capital, a NY-based activist fund, submitted a public letter highlighting the aforementioned missteps and calling on the board to make a change in leadership. On 9/18/17 it was announced that Ted Owen was stepping down as CEO.
1) TISI’s poor operating performance is primarily self-inflicted and temporary in nature.
I believe margins will recover to historic levels as labor utilization rates improve and operational disruptions recede. Team has a long public history of generating robust free cash flow and earnings. In fact, 2017 is the first year in its public history that Team has not had positive EPS. In my research, I have yet to uncover anything that has structurally changed about Team’s business or the industry it operates in.
In addition, I am comfortable with the circumstances that led to the margin pressure. Decision makers at service businesses broadly (such as CROs, consulting firms, etc.) are always balancing how many people to employ. If they staff too little, and demand is higher, they lose market share. If they staff too much, and demand is lighter, they get squeezed on margins. I think this is what happened to Team. When Team was a smaller company and their end market was stable, forecasting demand was a much easier proposition. However, visibility was particularly limited these past couple years as Team was integrating two major acquisitions while running four different ERP systems. Exacerbating these woes, Team’s management completely underestimated the weakness in their end market. It all makes sense.
The good news, is that labor utilization is an issue that is relatively easy to fix: You lay people off and consolidate a few branches. This is exactly what Team announced in Q2 – a restructuring that will result in $30mm in run rate savings. The majority of the cuts were focused on right-sizing the mechanical services business. A lot of these underutilized employees had joined Team as a result of the recent Furmanite deal. We also learned on the Q2 call that the ERP implementation is 70% complete and should wrap up by year end. Even if it drags on for another quarter or two, within a reasonable period of time Team will begin to realize the expected benefits of the new system (better data, SG&A efficiency, working capital improvement). In fact, Greg Boane, TISI’s CFO, is confident that the new ERP system will enable TISI to reduce A/R DSO by 15 days (which would release ~$50mm in working capital).
2) Significant deferred maintenance by refinery customers lays the foundation for a healthy demand backdrop.
Many of the refinery assets in the U.S. are owned by integrated oil companies. Low oil prices have caused a substantial reduction in upstream profit and cash flow which has led to cutbacks on downstream spending - both for capex and discretionary maintenance. If you look at the downstream capex segment disclosures for Exxon, Chevron, BP, etc., you will see a meaningful decline in spend in the past couple years. This trend is also apparent in data released from IIR (Industrial Info Resources) which tracks refinery turnarounds. The IIR data shows that planned refinery turnarounds (which are very important for TISI) have declined substantially in the past couple years. This dynamic is the primary reason that TISI’s mechanical services revenue is 20% off peak levels (in addition to a modest amount of share loss). Not surprisingly, unplanned turnarounds are starting to tick up. Unplanned downtime is extremely expensive for refineries due to inefficient labor costs and lost production. My conversations with industry participants supports the notion that there is pent-up demand for downstream maintenance and capex.
Here is some recent commentary from public companies involved in downstream maintenance that also supports this perspective.
- “During the second half of 2016, the markets declined as customers deferred spending and this caused our revenues and profit margins to decline as well. We are now in the middle of the spring 2017 turnaround season and we have not yet seen a significant improvement in market conditions.” MG CFO, 3/17/17
- “As it relates to refinery turnarounds, our support services that are assisting our clients' turnaround planning efforts would indicate that the fall of calendar 2017 and calendar 2018 will be considerably stronger than previous periods.” MTRX CEO 2/9/17
- “Results in Q4 were disappointing, as we faced continued contraction in our markets due to the economic fallout of low oil patch activity, lower solar opportunities and a continued low level of major refinery turnarounds.” AZZ CEO 4/20/17
- “There is some pent-up demand on the turnaround side for the clients that we work for across the broad spectrum. Next year it'll be really nice. Therefore, based on the turnaround schedule that we see, like you said, pent-up demand.” PWR CEO 7/21/17
- “Planned turnaround activity in the U.S. is running about 40% of the past eight-year average for planned turnaround spend. And the 2018 backlog for planned turnaround activity now stands at about a 10-year high.” TISI CEO 8/8/17
3) Successful convert issuance materially reduces risk of financial distress.
Prior to the issuance, TISI had $357mm of secured debt. With the sharp decline in adj. EBITDA (to $58mm LTM), TISI was in violation of its senior secured covenants. To remedy this situation, TISI came to market with a convertible debt offering. Demand was healthy and the issue was upsized from $175mm to $230mm. TISI used the proceeds to pay down its entire term loan and put the remainder of the proceeds towards its revolver. PF TISI now has $150mm-ish of revolver outstanding (final amount depends on how much cash TISI keeps on its balance sheet) with a mid-2020 maturity. The senior secured covenants are now well covered (<3x TTM vs. 4.75x required as of 3Q’17).
The more restrictive covenant on the revolver is the total leverage ratio test which is set at 4.5x on 3/31/18. This would imply EBITDA of $84mm using today’s cap structure (required EBITDA will likely be lower as TISI is using every dollar of FCF to delever). While I don’t expect the company to trip this covenant (it could be tight though), I think it would be a manageable negotiation if they did. The revolver is held by BAML and JPM, TISI’s relationship banks. These banks are not in the business of foreclosing on companies that are in technical default, particularly when the debt they have outstanding is well covered and only totals 60% of outstanding A/R. Therefore, if TISI does end up tripping the total leverage covenant, I expect TISI to pay a consent fee and get a waiver – as they have done in the recent past.
4) Stock is far too cheap for a market leading company providing specialized, critical services in a growing end market.
When looking back, it is easy to see what people were excited about when the stock traded in the mid $40s. TISI legacy EBITDA was $91mm in FY’15. Add PF EBITDA for Qualspec ($24), Furmanite ($38), and believable synergies ($20-25) and it wasn’t hard to get to $175mm. The prior 10 years (’05-’16), TISI traded with a median EV/EBITDA multiple of 11.3x. Using 11x, that implied a stock price of $54/share.
At the same time, you had Ted Owen promoting a near-term EBITDA target of $200mm.
“By 2018, even assuming modest 3% growth targets, we believe that our total business should be achieving 9% EBIT margins and 13% EBITDA margins. That would represent an adjusted EBIT target of about $130 million and an adjusted EBITDA target of nearly $200 million on revenues of about $1.5 billion in 2018. That is the financial performance foundation that we're building.”
- Ted Owen 3/10/16. Reiterated 5/10/16, 8/9/16, 11/2/16, 3/8/17, and 5/10/17 (with updated caveat, it may not be achieved until the end of ‘18).
Given the actual LTM adj. EBITDA of $58mm (just a tad bit short of $200mm), it is not surprising why long-term shareholders felt duped. But just as $200mm was a stretch, $58mm is not anywhere close to normal earnings power.
At $13.45/share, the market is not giving TISI sufficient credit for the strong recovery in EBITDA that I believe we will see over the next 18 months. I calculate normalized EBITDA of $135mm (my #’s ding them entirely for SBC). I get there a couple different ways. First, I project each segment based on my view of normalized demand and historic EBITDA margins. My assumptions result in a consolidated EBITDA margin of 10.5%. This compares with TISI EBITDA margins from ’06-’15 of 10.8% and mix-adjusted (for acquisitions) median EBITDA margins of ~10.5%. Second, I bridge from today’s $53mm EBITDA (which includes SBC as an expense). I add in $30mm in savings from restructuring (already completed), $20mm in future efficiency gains, process improvements, cost savings, and incremental Furmanite synergies. I then assume a 10% top line recovery at 25% incremental margins (another $30mm).
Using $135mm in normalized EBITDA, TISI is trading at 8.1x P/E, 12.0x EV/NOPAT, and 5.6x EV/EBITDA. That is way too cheap. The current EV is $750mm. That seems a little silly considering TISI did $91mm in standalone EBITDA and just paid $590mm for two acquisitions.
I value TISI using both a DCF and a multiple of normalized unlevered earnings power. My exit multiple assumes that TISI trades at 15x P/E (vs. its 10-year median of 24.8x). This gets me to a value of ~$22 today. This is approximately the strike price of the convert ($21.70) so it doesn’t make too much of a difference to my value if you treat the convertible notes as debt or equity. TISI is a full tax payer so any benefit from reform would be gravy.
What about the convert?
I think it is attractive as well. At $95.75 the YTM is 5.9%. If I’m correct that the FMV today is ~$22, and that fair value grows 9% per year for the next six years (to maturity), the convert would return an IRR of 14.3% with a 2.1x MOC. Using the same assumptions, the equity IRR would be 18.0% with a 2.7x MOC. If my base case was certain, you’d just buy the equity. But while I can think of a few downside scenarios where TISI needs to issue additional equity, I find it hard to envision one where the converts don’t get at least par. I feel pretty comfortable owning any security where the reasonable downside risk is a ~6% annual return.
- Continued operational challenges lead to cash burn, covenant defaults, and financial distress.
- New normal for downstream maintenance.
o Macro remains unaccommodating (oil prices and crack spreads remain low) squeezing customers’ profits.
o Pricing environment remains soft as excess labor capacity lingers.
- Refiners get more efficient at procuring maintenance services.
- Management change leads to improved operational discipline.
- Pickup in turnaround activity.
- Activist involvement keeps pressure on.
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