All credit for this idea goes to Peter Rabover from Artko Capital, who helped outline the thesis in his latest quarterly letter to partners. I have shamelessly cloned Peter in the past, and this is no different.
After a rough few years for EEI, I’m convinced that it’s time to re-visit this idea, as I think there exist multiple catalysts to share price appreciation now (despite the stock being up some 35% from a year ago), and this looks like a good situation to step in front of given Mill Road Capital’s involvement, a recovery from cyclically low operational results in non-US segments, and a cash-rich balance sheet that provides a ton of flexibility. Companies that fit the characteristics and low valuation of EEI have a good chance of getting acquired, and this situation is no different (although there should be value creation outside of an acquisition).
I’m a little late to the story here, having missed the opportunity to purchase shares a few months ago at a lower price, nevertheless I wouldn’t be surprised if EEI’s intrinsic value is somewhere in the $18-$23 range using a median peer multiple of $8-10 EBITDA plus $15-17mm in net cash divided by 4.3mm shares.
Business Description
EEI is an environmental consulting services company. The company has completed thousands of services for a wide variety of clients, and has operating subsidiaries in 5 countries, including their South American operations in Brazil, Chile, and Peru. Judging from the above, MCC members are familiar with the business, which consists of the company charging labor hours for services ranging from things like renewable energy projects, water treatment services, mining permit assistance and many others. Services are provided under three types of contracts, time and materials, fixed price, and cost-plus, which make up 47%, 37% and 16% of total revenues. The company has two main operating segments, US and South America, which make up 78% and 21% of revenues (with a smaller ‘other foreign subsidiary’ making up the remaining 1%, but it’s my understand the company is winding down some money losing foreign operations). The environmental consulting service business isn’t terrible. The model is characterized by high labor and subcontract costs, but decent EBITDA margins and high free cash flow generation due to low capex needs. Over the past three years, the company has spent something like $2.1mm in capex while bringing in $14.5mm in free cash flow. Through Q3 2018, EEI generated $5.1mm in free cash flow. For a $43mm EV company, this looks pretty attractive, especially when factoring in money-losing foreign operations (appearing to be rebounding now), and a large net cash position ($16mm).
Why the Mispricing?
As most are more than familiar with, the company ran into some operational issues over the past few years stemming from a decline in their South American business segment due to a multi-year recession, a business mix shift away from commercial contracts to more federal contracts which are billed at lower rates and subject to audits and readjustments, and slowed economic activity in the energy and mining sectors, key contributors to EEI’s total project count. A few poor years/quarters from an earnings standpoint in addition to the shareholder structure (majority controlled by a small, founding group) meant the market had seen enough and hammered the share price. But cash flow matters, and the company continues to generate significant free cash, has shuttered unprofitable business segments, has the patience/balance sheet to wait out a South American recession, and gained a new activist owner who acquired two new board seats, yet the market has barely given EEI any credit.
Despite shareholders waiting for some time now, I believe the risks to the investment today are very minimal (despite recent upward share price adjustment) and I’d be happy to wait out further operational improvements and continued cash flow generation.
Competitor Valuations
Back of the napkin valuations for some of EEI’s publicly traded environmental consulting services peers point to a pretty severe undervaluation from an EV/EBITDA, and P/FCF standpoint. EEI also has one of the more favorable capital structures. The below list comprises both environmental consulting companies, as well as IT and professional services consulting companies.
Despite the poor results over the past few years in the company’s South American operations, as well as the unfavorable super-voting share structure, EEI trades at a severe discount to its peers, and one which appears to be unwarranted. If we could get back in line with peer median multiples or close to it, investors could see significant share price appreciation.
Management
I’d imagine that one of the biggest hurdles for investors to get around would be the dual class super-voting share structure, and the fact that the founding members of the company, Ronald Frank (79), Gerald Strobel (77), and Frank Silvestro (80) own over 50% of the super voting shares. Class A shareholders hold 1/10th of the voting power of Class B shareholders.
With 4.3mm shares outstanding, I’d imagine (in addition to other things) this has prevented the company from repurchasing shares, especially during periods of low valuation. With EEI trading at a significantly lower valuation than its peers, buybacks would be very accretive, even below $14.00/share. Luckily, Mill Road Capital, a private equity group made up of former Blackstone guys has swooped in and acquired a load of A shares, won a proxy fight for two board seats, and (as detailed above) already offered to purchase the company for $13-14/share (an offer that was immediately turned down by the control group). Since getting involved, Mill Road has implemented increased IR efforts, helped dispose of unprofitable segments, cut costs, and improved shareholder communication. My ‘captain obvious’ guess would be that Mill Road understands that the business is worth much more than the current valuation, and will help oversee the creation of shareholder value moving forward. They have had success in the past with finding acquirers for their businesses, including Rubio’s Restaurants and R.G. Barry.
We’ve seen some share repurchases from insiders (Ronald Frank) as well as Mill Road Capital dating back to April of this year, which further drives some confidence that there is value to be realized above current prices.
Valuation
I’d peg normalized free cash flow moving forward at around $5-7mm, using a 1.5% – 3% growth rate, which doesn’t really factor in much business or operational improvement, both of what we’ve seen in the past few quarters. Using a 12-15x free cash flow multiple on $7mm in free cash for 2018 and dividing by 4.3mm shares gets us to a share price range of $19.50 – $24.45. There is $3.70/share in cash on the balance sheet.
It doesn’t seem like a lot has to happen in order for the company to unlock some additional value. Add in the company’s untapped balance sheet, activist shareholders with experience in getting their portfolio companies acquired, and what appears to be a rebound in foreign operations, one can see why this may now be the right time for EEI shareholders to benefit. I don’t make investment decisions based off of dividends, but the 2.9% yield isn’t a bad thing either, with plenty of free cash flow to pay the dividend, and a long history of doing so. Shareholders over the past few years may not be thrilled with returns (although shares appear to be up 35% or so since 2015), but sometimes value investing can be a waiting game, where you know there are returns available, but you just don’t know when. EEI has some built in catalysts and appears poised to generate favorable returns moving forward.
I have to get more comfortable with the company’s backlog of work and how likely it is to be realized, issues surrounding receivables including unbilled work, and details surrounding the actual consulting contracts, and I have to keep a close eye on how South American operations unfold moving forward, but I feel comfortable enough in the undervaluation and additional factors to initiate a position for the time being.
Long EEI.
Here’s a solid VIC writeup from May 2017:
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