Description

ADF Group is a leading North American steel fabricator with a particular focus on designing and engineering complex steel structures for non-residential construction projects.  I believe that the business is currently at a major inflection point, and as such is poised for both a sharp acceleration in revenue growth and expanding operating margins.  

I currently expect revenue growth of 60% and EBITDA growth of 100% in the current fiscal year, excluding all COVID-related government subsidies, which should in turn drive a significant revaluation in the share price.  Shares are currently valued at 5.7x TTM EBITDA (ex-subsidies), but only 3.2x my expected current year EBITDA.  I believe that the business is worth around $5.00 per share, which is more than double the current share price and is roughly 8x EBITDA and 13x FCF.

Shares trades as DRX on the TSX in Canada and as ADFJF on OTC Markets in the US.

Overview

ADF designs and engineers complex steel structures for a wide variety of construction projects, including: office towers, airports, stadiums, manufacturing plants, warehouse/distribution facilities, and transportation infrastructure.  Some of their sample projects include Miami International Airport, One World Trade Center, M&T Bank Stadium (home of the Baltimore Ravens), Daimler-Chrysler Automotive Plant, Goldman Sachs HQ, and Logan Airport’s pedestrian bridges.

They have historically focused on complex construction projects which possess higher pricing and benefit from less competition as fewer fabricators are equipped to work on these projects for a number of reasons:

• Larger-scale components require a larger fabrication base and greater lifting capacity.

• Strange angles (i.e. non-right angles) involve more complex welding.

• A more specialized labor force is required.  It takes them 6-12 months to train and ramp up a new employee.

• Other special equipment is often needed to handle non-standard work.

ADF currently has two facilities -- a 635k sqft plant in Quebec, and a 100k sqft one in Montana that was built in 2015.  Roughly 95% of revenues have historically come from the US and only 5% from Canada.

Backlog Growth

I’ve focused my attention on backlog growth and not revenue growth because COVID delayed the timing of many recently awarded contracts, which has masked some of the underlying growth in the business.

ADF has been on a strong growth trajectory with three consecutive years of backlog growth -- 157% growth in FY19, 50% growth in FY20, 33% growth in FY21.  This allowed ADF to enter the year with an enormous backlog of $436 million, which I believe positions the company for a record year with ~$275 million in revenues, an increase of 60% over the prior fiscal year and over 50% higher than their previous record year.

More importantly, however, management has telegraphed a very strong outlook for future backlog, which should in turn drive even more revenue growth next year.  Their AGM presentation specifically highlighted that the number of projects out for bid has doubled from FY20 levels.  The letter to shareholders in the most recent annual report summarized it as follows (emphasis mine):

“The growth of the order backlog remains one of our priorities, and we are making every effort to achieve the intended results. That is why we are confident that we can maintain the backlog’s current level and even improve it. There is a strong pipeline of potential projects in our markets, both in Canada and the United States, and the number of projects on which we are competing for, that are at different stages of the bidding process, many of which are in the negotiation stage, remains high.”

Revenue Growth Drivers

As for what is driving some of this recent growth and optimism for future growth, I wanted to highlight two factors.

First of all, it appears that there is generally a strong macro environment for the types of construction projects that ADF works on, both in the US and Canada.  This is important, not just because it provides the company with higher levels of project volume to bid on, but the higher volume environment (perhaps not surprisingly) also generally leads to better project pricing with higher margins.

Furthermore, it is obviously well-known that there is >$1 trillion in infrastructure spending currently working its way through congress.  Management specifically highlights this planned spending (in addition to $300+ billion from New York State) in their optimism for future growth.

Secondly, on a more company-specific level, ADF has a strong growth outlook in the large surface commercial building segment.  This is essentially more standard, “square box” construction like warehouses.  It’s lower margin work, but it’s also very high volume where they can do a lot of tonnage in a very short period of time.  This has historically been only 5-10% of their business, but is now running closer to 25%.

My sense is that they’ve historically avoided these sorts of “standard” projects as they’ve been apprehensive about tying up their capacity with lower margin work that their labor force is essentially overqualified for.  This would make sense if it wasn’t for the fact that their capacity utilization at both plants is only around 50%.  

I think they’ve now realized that they can use these standard projects to drive throughput at their facilities, and thus achieve better fixed cost absorption.  As a result, the company is now bidding on a lot more of them and sees a strong growth outlook in this segment.  As for why now, I think that there’s just a lot more of these standard, high volume projects being built than there have been in the past, driven in large part by continued e-commerce growth and the need to build out local distribution infrastructure. And this increase has finally convinced management to get more aggressive in this segment.  Amazon alone has announced that they’ll be building over 1000 of these buildings over the next year or so (some of which DRX will be working on), and I know that Wal-Mart has similarly been making significant investments here as well.

Capacity Utilization and Operating Margins

While I am expecting around 60% revenue growth this year, I believe that this growth will be significantly enhanced by operating leverage, which should drive around 100% EBITDA growth.

ADF has been running their facilities at ~50% utilization, which has not surprisingly hampered margins and returns on capital.  Of particular note, the business has fairly consistently traded well below its $3 per share in tangible book value, despite its business almost entirely consisting of highly specialized, non-commoditized work.

As the company ramps up revenues and better absorbs its fixed costs, I believe it should drive EBITDA margins (ex-subsidies) from 6% in the TTM to over 9%.  To be clear, however, I have only modelled 7% EBITDA margins this year to be conservative.

This is why I feel that the business is at a major inflection point today.  They are on the cusp of meaningful revenue growth (which is already telegraphed in their backlog) that will drive a dramatic increase in EBITDA due to the underlying operating leverage and the low margin, subscale nature of the business today.  I find that the market tends to greatly underestimate the magnitude of these sorts of economic transformations, hence the significant discount to fair value in the current share price.

There are additional potential margin improvements that can be realized through automation investments.  As they ramp up their large surface commercial business, it may make sense for them to invest in more automation to eliminate some of their labor costs.  They are presently evaluating this and have some investments planned for the FY22-FY23 time frame.

Valuation

In the TTM, the business did $177 million in revenues, and excluding all COVID-related subsidies, had roughly 12.5% gross margins and produced $11.2 million in EBITDA.  I have excluded all COVID-related subsidies from my analysis to be conserative, and did not adjust for the incremental costs that the business undoubtably incurred as a result of the pandemic.  The TTM includes Q1 of the current fiscal year.

I currently expect the business to do around $275 million in revenues, ~14% gross margins, and produce $25 million in EBITDA excluding all subsidies.  As it is difficult to be precise on revenues for the year due to project timing, and because the ramp in the business is so significant, I have arbitrarily haircut my estimates and am currently only modelling $20 million in EBITDA for this year.

With a $64 million EV and $20 million in EBITDA, the valuation on this year’s EBITDA is 3.2x.  

That $20 million in EBITDA should in turn drive around $12-13 million in FCF.  From the $20 million I subtracted $3.4 million in capex which is the current depreciation rate (capex has generally been $1.5-2.5 million, although $5 million is expected this year), $1.0 million in lease payments, and $3 million in taxes (although they have $33 million in US NOLs and haven’t been paying cash taxes so I suspect cash taxes will be well below this figure).  With $12-13 million in FCF, that puts the current valuation at 5x FCF.

I believe the business is worth around $5.00 per share, which puts the valuation at 8x EBITDA, 13x FCF, and 1.65x tangible book value.

I think one of the largest reasons why the stock is so undervalued today is because of how under-the-radar the company is.  I think last quarter might have been the largest EBITDA quarter in the company’s entire history and there was not a single person on the conference call.  That is extremely unusual for a $50+ million market cap company IMO and suggests that investors just haven’t noticed the transformation that’s occurring in the business yet.

Ownership

ADF Group has very high insider ownership as it is 45% owned, and voting controlled through dual class shares, by the Paschini family.  Each of the CEO, COO, and an EVP own 15% of the shares.  The business was founded as a blacksmith shop in 1956 and is now run by the three children of the founder.

While I know that voting control can give some investors pause, I have no issue with it at ADF.  Management has economic ownership that is both very significant in the absolute (45% of the company) and relative to their salaries.  I have not seen any evidence of management trying to abuse its voting control.  I think that management’s significant economic ownership aligns them well with shareholders.

Risks

• If they bid poorly or encounter unforeseen issues, they can earn less money than expected on a project, or even potentially lose money on it.

• They could invest in plant upgrades that generate a poor return on investment.

• A downturn in the economy could reduce the number of infrastructure projects available for them to bid on.

• Revenue growth could fail to translate into margin expansion if they do a poor job of managing a large increase in the size of the business.

Catalyst

• The next three quarterly reports.  The business is poised for a meaningful ramp up in revenues and I expect each quarter this fiscal year to be larger than the prior one.  As a result, I believe that demonstrating continued strong growth in the business at attractive margins should serve as a strong catalyst for the share price.

• Announcement of significant new orders that increase the size of the backlog.  Management is very bullish on backlog growth and they do periodically announce large groups of orders, so I suspect at least one of these announcements before the end of the year.

• Increase in the dividend.  The company pays a small $0.01 semi-annual dividend.  If the company was to use some of their increased cash flow to pay a larger dividend, it could attract new investors to the company.

• A sale of the company.  This is a family business run by the children of the founder.  It’s technically possible that it gets passed down to a 3rd generation, but I think it’s far, far more likely at some point to be sold.  I doubt that will happen in the next few years, but you never know.