|Shares Out. (in M):||9||P/E||11.4x||8.7x|
|Market Cap (in $M):||180||P/FCF||7.2x||6.0x|
|Net Debt (in $M):||0||EBIT||0||0|
|TEV (in $M):||0||TEV/EBIT||0.0x||0.0x|
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Founded in 1940, Michael Baker Corporation provides engineering, design, planning and construction services mainly in the United States. The company operates in two defined business segments: Transportation (civil infrastructure engineering) and Federal (Departments of Defense & Homeland Security). Michael Baker specializes in projects in the fields of aviation, defense, environmental, geospatial IT, homeland security, municipal & civil, oil & gas, rail & transit, telecommunications & utilities, and water resourcing.
The engineering and construction industry is dominated by a handful of large firms operating worldwide. Michael Baker, with its $180 million market capitalization, focuses solely on engineering and design, which is a niche segment within the industry. Most engineering and design firms tend to be small regional companies, bidding on projects that are within their municipality or state. From its beginnings, Michael Baker formed a strong relationship with the US military and to this day continues to serve both the Department of Defense and the Department of Homeland Security (FEMA). This has helped the company expand beyond its home base in Pennsylvania. Over the last two years, Michael Baker has actively expanded its revenues and national footprint through the acquisition of LPA Group in May of 2010, JMA Architects in June of 2011 and RBF Consulting in October 2011. LPA Group added the expertise of aviation, highway & bridge design, and transportation infrastructure while at the same time expanding Michael Baker’s reach into the lower eastern states such as Florida, Alabama, Tennessee, Arkansas, and Midwestern states like Missouri. The JMA purchase was a bolt on acquisition to transition Michael Baker into the growing market for healthcare and hospitality design. RBF Consulting helped expand Michael Baker’s western footprint and diversify its revenue base into land development, municipal works, and water resources. Except for a handful of states where the firm has very little representation, Michael Baker has developed into a national engineering and design firm.
Even with all the positive expansion within the company, Michael Baker has currently struggled to grow its revenue base. The company is highly levered to the public sector, generating approximately 85% of its revenue from federal, state and local projects. All of these projects require legislative approval, which in turn has created a significant amount of uncertainty. Recently, the Moving Ahead for Progress in the 21st Century Act (MAP-21 – surface transportation bill) and the FAA Modernization and Reform Act of 2012 were signed into law providing $105 billion and $63 billion in funding respectively. However, the funding from these acts pales in comparison to the looming Budget Control Act of 2011 which slashes the Federal Government’s budget by $2 trillion over a 10 year period if a compromise cannot be reached on the current “fiscal cliff.” Even if a compromise can be reached, it is just as likely that federal construction projects and state funding may be delayed or sidelined because of the reduction in government expenditures. In total, Michael Baker is carrying a contract backlog of engineering and design projects that total $1.65 billion ($635 million funded and $1.015 billion unfunded). A funded backlog is uncompleted work represented by signed contracts and/or approved task order where funds have been allocated and work is expected to be completed within the year. An unfunded contract backlog is represented by a signed and/or approved task order where the funds have not been allocated to pay for the project and a start date remains undetermined.
Michael Baker has witnessed revenue from the Federal Government fall from 49% to just 27% of its overall revenue from 2009 to its most recent quarter. This is due, in part, to reduced spending by the Federal Government on defense infrastructure (draw down of oversees troop deployment and defense construction within the US) combined with an increase in revenues from acquisitions (LPA Group and RBF Consulting) that focuses primarily on state and local government projects. In addition, because of the slowdown in projects from both revenue segments, Michael Baker’s gross margins have fallen nearly 400 basis points in the past 18 months. Management continues to search for the correct balance of staff needed to fulfill funded, unfunded and future projects vs. managing the company’s margins and utilization rate. Of the two revenue segments, Federal continues to maintain a higher margin and utilization rate mostly because the projects have a longer duration, a larger revenue base and can be more actively managed. Transportation margins have been lower as staff continues to be under utilized by comparison.
Since early 2010, Michael Baker focused on growing revenue and earnings through strategic and bolt-on acquisitions. In its most recent quarterly results, management announced that it will change course; focusing on organic growth through integration and optimization of operations through work sharing and enhanced cross-selling. Past acquisitions inflated the company’s amortization expense, which will decline and be worked off over the next five years, especially if no new acquisitions are added. As part of a campaign to align expenses with revenues, Michael Baker announced an $18-$20 million cut in expenses over the next fiscal year. Additionally, management initiated a quarterly dividend (currently yielding 3%) and a $10 million share repurchase program. Guidelines surrounding company stock ownership has been adopted and will be implemented over the next five years. The guideline calls for the CEO and management team to hold 5x and 3x their base salaries in company stock respectively. The board of directors will be required to own 4x their cash retainer in stock.
The transformation from acquisition to organic growth, initiation of both a quarterly dividend and a share repurchase program, and stock ownership guidelines, directly answers recent criticism surrounding the alignment of Baker’s management with its shareholders and the best use of the company’s cash. The money to be spent on share repurchases and dividends will not negatively impact the balance sheet and can more than easily be covered by the yearly production of free cash flow.
FEMA (Federal Emergency Management Agency) represented 8% of Michael Bakers’s revenue in the past year. Expectations are that FEMA’s revenue contribution will continue to grow in size and scope as Hurricane Sandy laid a clear path of destruction in the company’s back yard on the eastern Seaboard. FEMA projects fall under the auspices of the Department of Homeland Security. As such, these projects are often fast tracked and take a higher priority than maintenance or renovation projects. New Jersey Governor, Chris Christie, has asked FEMA for $37 billion to cover the damage created by the storm. New York Governor, Andrew Cuomo, has separately petitioned FEMA for $33 billion for storm damages and another $9 billion to build infrastructure to prevent future storm damage from escalating. Between the two states it is estimated that $15 billion will be needed to repair roads, bridges, water systems, and schools.
Michael Baker’s revenues and earnings have been negatively impacted by the slow down in the scale and number of active projects. This in turn depresses revenues, margins, utilization and profitability for the company. Even with the current backlog of $1.65 billion in both funded and unfunded projects, continued uncertainty surrounds the economic recovery. Earnings growth in the short-term will depend on how quickly Michael Baker can restore its margins. Some of the margin erosion can be addressed by management’s $18-$20 million reduction in planned expenses, as-well-as continued decline in amortization expenses. However, real operational leverage and earnings power will only come from restoring the company’s utilization rate, and that will be achieved when federal, state and local governments begin to address their decaying infrastructure in a meaningful way. Unfortunately, there is no clear indication of when that might occur.
Taking the lower end revenue guidance for fiscal year 2013 of $583 million and applying conservative measures for gross margins, SG&A and reduced expenses, yields an EBITDA number of $36.3 million. Applying amortization and taxes, produces a net income number of $15.8 million or $1.65 EPS. If Michael Baker were able to achieve $610 million (the higher end of the range) in revenue and assuming that the increase in revenue benefits staff utilization and margins by 50 basis points, than the resulting net income number would be $20.6 million or $2.15 EPS.
Michael Baker’s robust balance sheet with no debt, $67 million in cash (~ $7.00/share) and a line of credit of $50 million (recently reduced from $125 million) provides significant downside protection for the company. The yearly free cash flow generated will more than cover the dividend and share repurchases, assuming all $10 million worth of shares are repurchased.
Michael Baker is positioned to benefit from a rebound in infrastructure spending. The company focuses solely on engineering and design, which is a niche segment of the much larger engineering and construction industry. Although “shovel-ready” projects have been touted and promised by many politicians as a way to jump start the economy, they have yet to appear in a meaningful way. Legislative acts that promise funds for infrastructure and renovation, like MAP-21 and the FAA Modernization and Reform Act of 2012, can easily be overshadowed by the looming fiscal cliff and the Budget Control Act of 2011. Continued neglect, delayed maintenance repair and upgrades will eventually force federal, state and local municipalities to take action regardless of their budget conditions. The real question is: Will Michael Baker be able to sustain its current revenues and/or improve profitability while it waits?Through its recent acquisitions, management has diversified and expanded the company’s footprint as well as gained an expertise in growing engineering segments. Given Michael Baker’s balance sheet and operational leverage, it will not take a significant growth in revenue for their profitability to be positively impacted. An increase in projects will bolster revenue, increase staff utilization as well as margins and be reflected in greater profitability. A 4.6% growth in revenue can easily be manifested in a 30% growth to earnings. With its initiation of a 3% dividend and $10 million share repurchase, Michael Baker is trying to reward its share holders and implicitly ask for their patience.
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