Description

In my personal view, modular buildings are one of the best alternative asset classes that most investors have never heard of.

Trevor Haynes, CEO of Black Diamond Group Ltd.

Investment Case:

In 2016, Black Diamond Group (BDI.TSX) was on its back. Co-Founder and CEO Trevor Haynes had built BDI up to a market capitalization of 1.3 billion CAD only to watch it nosedive to about 300 million CAD. His own net worth tied up in BDI shares that were once worth over 86 million CAD, had plummeted. Things would get worse before they got better – BDI’s market capitalization would bottom out near 100 million CAD. But, in 2016, the fate of the business “came down to a very succinct strategic pivot” (https://businessincalgary.com/top-news/pivoting-towards-the-future/). A tenacious, but humbled CEO Haynes made a strategic pivot to turn BDI into a diversified modular building rental business and away from its roots providing lodging rentals to the boom-bust Canadian oil and gas sector. It was a slow, multi-year process, and now finally, BDI is at the inflection point of a much higher quality business with a long tail of growth potential that has not been fully appreciated by the market.

What Trevor saw in modular buildings was assets that had a high long useful life of two to three decades, yet low maintenance capex required throughout the useful life and lengthy customer rental duration of ~4.5 years. This all helps to explain the ~20% return on assets BDI earns on shareholder capital. BDI is able to protect this return profile due to local economies of scale and a relatively price-insensitive customer base that is focused on service, safety, and reliability. During a cyclical downturn, BDI can turn off growth capex, and the stickiness of the customers allows its modular business to generate significant free cash flow. The lengthy duration and stickiness of customers can be explained by significant “exit costs” related to returning a unit back to the company. Exit costs include pick up cost, restoration cost and damages beyond normal wear and tear. These interesting and durable characteristics are why Trevor believes modular buildings are one of the best alternative asset classes that most investors have not heard of. Yet, this business trades at just 6x 2025E EBITDA.

Upside from here comes from low-double digit EBITDA growth in 2025 and beyond + multiple expansion + two call options.

EBITDA Growth – Transitory rental timing issues are impacting 2024 and weighing on shares. EBITDA growth in 2025 is shaping up to be strong as assets are re-rented at much higher rates (post-COVID vs. pre-COVID prices) and new assets are deployed. As of 1Q24, BDI’s future modular purchase commitments are +11% y/y. This is an important but often-overlooked leading indicator as BDI has already secured customer contracts for the majority of these units.

Multiple Expansion – High-quality rental businesses (URI, AHT LN, WSC, and MGRC) tend to trade in the 8x-10x FY25 EBITDA range. Takeout multiples have been in the 10x-11x EBITDA (trailing twelve months) range. In February 2023, McGrath RentCorp acquired Vesta Housing Solutions for 10.0x. In August 2021, United Rentals, Inc. acquired General Finance Corp. for 10.6x. In March 2020, WillScot Corp. acquired Mobile Mini, Inc. for 11.4x. In 2018, WillScot acquired Modular Space Holdings, Inc. for 9.9x. We believe BDI deserves to trade at least 8.0x FY2025 EBITDA given its runway for growth across the United States.

Two Embedded Call Options – 1) Hidden asset in LodgeLink – a fast-growing B2B corporate crew booking platform. 2) Accelerated growth optionality given the multi-year implications of the proposed merger between McGrath RentCorp (MGRC) and WillScot (WSC). This merger (announced January 29, 2024) could further solidify pricing discipline throughout the industry. History suggests that when WillScot swallows a sizable competitor, market share could be relinquished as customers prefer to dual source and redundant sales talent is lost. If regulators approve the deal, BDI should benefit from a near-term reshuffling of market share and people within the industry.

We believe BDI shares could be worth 14 CAD based on a reasonable 8x times 2025 EBITDA. Again, this assigns no value to LodgeLink and does not assume the McGrath/WillScot merger closes.

Long-term, BDI is a sleepy compounder benefiting from secular industrial tailwinds (low single-digit volume growth), solid industry price discipline, growing value added products and services penetration (modest tailwind on pricing), and share gains that altogether underpin low-double digit average EBITDA growth. Current consolidated EBITDA margins of 27.1% can inflect much higher as BDI continues to gain further scale as major competitor WSC generated 44.9% adjusted EBITDA margins for 2023, and WSC is targeting 50% EBITDA margins in the next 2 to 3 years. With a consolidating industry, further inorganic growth is also possible as BDI’s balance sheet is relatively clean when compared to peers. BDI ended 2023 with 1.7x of net debt to 2023 adjusted EBITDA. This compares to other modular peers such as MGRC which has 2.4x of net leverage and WSC has 3.3x of net leverage.

BDI Overview:

Black Diamond is a diversified, specialty rental platform with two operating business units: Modular Solutions (MSS) and Workforce Solutions (WFS). Black Diamond generated $393.5mm of revenue in 2023. MSS generated $206.7mm (52.5% of revenue) and WFS generated $186.8mm (47.5% of revenue). The rental revenue end-markets exposure breaks down in the following way: 30% construction, 19% education, 11% government, 7% mining, 8% oil and gas, 15% power and energy infrastructure, and 10% in other. The focus of the analysis will be on MSS because this is where the incremental capital is being allocated to as part of the “strategic pivot” mentioned above.

MSS owns a large rental fleet of 11,339 modular buildings. MSS distributes its rental fleet through a network of 23 local branches that deliver and service units to a diverse customer base. These modular buildings are “single-wide” units that can be combined into office units, lavatories, storage units, large multi-unit office complexes, classrooms, banking facilities, health care facilities, high-security buildings (police stations), and blast-resistant structures. MSS generates revenue from renting modular units, selling modular units, and providing services related to modular units. MSS generated $85.4mm of rental revenue or 41% of MSS segment revenue, $65.2mm of sales revenue or 32% of MSS, and $56.1mm of services related revenue or 27% of MSS in 2023. Sales revenue consists of selling “end-of-life” units to third parties. What is unique to this industry is that even though the useful life for BDI in “GAAP accounting terms” might be two decades, BDI can refurbish and sell a unit for 50% or more of the original purchase price of the unit (even after 20 years of usage). Services revenue includes delivery revenue, installation revenue, pick-up revenue, and restoration revenue to restore a returning unit to its original form. These service fees can be a significant percentage of the annual leasing cost and actually help explain the sticky rental terms as the average duration of rentals is 52 months.

WFS owns a large rental fleet of 6,148 modular accommodation assets. These assets are used as relocatable dormitories, kitchen/dining complexes, recreation facilities, and supporting utility assets that give customers flexible and expedient solutions to accommodate their workforce in remote locations where local accommodation infrastructure is either insufficient or nonexistent. Embedded in WFS is an emerging digital marketplace for business-to-business crew accommodation, travel, and logistics services across North America called LodgeLink. LodgeLink generated $9.8mm of revenue in 2023, which has grown 160% over the past 2 years and is on the cusp of EBITDA breakeven. During the November 2023 Investor Day, management communicated ambitious plans to achieve $1bn of gross bookings and $100mm of net revenue in the next 3 to 5 years.

Modular Units 101:

BDI rents and services modular buildings that provide “temporary space” for industrial and educational end users (classrooms). Modular buildings are a quick-to-deploy solution to the thematic issue of long lead time construction of fixed buildings such as schools that require a couple of years to build. Modular buildings can also be slotted into remote locations within days’ notice. Although deemed “temporary” solutions, BDI rents out modular units for an average of 52 months. There are a number of structurally unique reasons why modular rental units are sticky and thus allow BDI to earn attractive returns on capital for shareholders.

We studied several customer contracts to better understand the business. A publicly disclosed school contract (dated November 2017) for modular units rented out to the California School District of San Rafael suggests that the cost to dismantle and return a standard classroom is 80% of the annual rental cost. Per the contract, the annual lease rate for one standard classroom cost $6,624 per year. The cost to “dismantle and return delivery of existing building” was $5,325. These significant “exit costs,” yet relatively low cost compared to alternative solutions (raising taxes and constructing permanent fixed buildings) help to explain why the average rental duration is a lengthy 52 months or ~4.5 years.

Currently, across its fleet, BDI rents out units for an average monthly rental rate of $764 or ~$9k per year. BDI also charges customers for the delivery of units, the pickup of units at the end of term, and any damages to the unit. Written in the customer contracts, customers are expected to return units back to the original condition in which they were delivered. As illustrated in the classroom example above, the end-of-rental term service cost can be significant. However, it only costs BDI ~$50k to buy a new modular unit, and the unit undergoes mid-life maintenance refurbishment that costs only ~$10k. Per the BDI March 2024 Investor Presentation, the current unit economics of a modular building consist of 17% annualized returns on initial investment over the practical asset life of two to three decades. The average payback period is ~5 years. What is unique to the industry is that used assets can still be sold at a premium to net book value even after decades of use. In certain cases, modular units can be sold at 50% to 100% of the original factory cost. The attractive returns on capital and the duration of these returns beg the question: why aren’t these returns competed away?

Competitive Moat:

There are a couple of barriers to entry. The first are the stockyards, where units are stored and serviced. If one were to visit a stockyard, they may not be impressed by them. However, a key measure of success is the density of customers per stockyard. BDI has 23 stockyards serving 11k modular units and 6.5k modular accommodation units. The average number of units served by BDI is over 750 per stockyard. Competitors WSC and MGRC are closer to 1,000 units per stockyard.

Localized Economies of Scale: Simply put, a local yard is necessary to compete, and to efficiently operate a local yard requires a minimal threshold of density /scale to be profitable. Similar to the aggregates industry, the cost to deliver/ship a modular is very high which limits competition to those with a local yard and prevents out-of-town, out-of-state competition. If you have a yard, density of customers served is paramount in terms of achieving efficiency of delivering units, picking up units, servicing units and deploying VAPS (value added products and services related to renting out ancillary products like AC units and office tables).

Trusted customer relationships and relatively low cost to criticality: It is not hard to build a stockyard from scratch and to buy some modular units as it may take only a year and a couple million dollars to set up the business. The issue is building a customer list that allows for scale efficiency to achieve attractive returns on capital. Obtaining a long customer list per stockyard is difficult because there is a level of trust and reliability that is required. For example, within the education segment, selling into school systems is a difficult process that requires passing through a lot of bureaucratic red tape. Having modular units that work well provides stickiness, and school rental terms of 3-5 years also help. To rip and replace BDI out of a school, a new entrant would wait out a rental term and then come in at a much lower price point to potentially persuade the school board to switch over. The school board cares more about a reliable provider that is responsive and can come in for repairs. Modular units need to be moisture controlled/mold resistant, and well ventilated. In short, the schools are not as price sensitive as they are concerned about students’ safety and the supplier’s reliability.

For industrial applications like construction sites, the renting of modular units for on-site office space may be mandated by union rules (break room). The rental cost of modular units is described as a small line item that doesn’t move a needle compared to the overall budget of a construction project. Reliability and delivery are key to construction general contractors, not price as construction delays or non-union compliance can be costly. In sum, modular rentals are a necessity that is relatively low cost but critical for customers.

Industry Outlook/Growth:

According to WillScot’s Q4 2023 earnings presentation materials, the North American market for flexible space solutions is over $10bn. The industry consists of two major competitors: WillScot Mobile Mini and McGrath RentCorp. There are a handful of regional players like BDI and then mom-and-pop outfits in nearly every market. Overall, the outlook for the modular rental industry remains positive. All signs continue to point toward solid price fundamentals and volume drivers. The WillScot/McGrath merger could further solidify these factors.

Price and Value Added Products and Services (VAPS): The industry has undergone significant consolidation. WSC has been leading the consolidation charge. WSC has done over 30 transactions over the past 7 years and has spent over $2.2bn. MGRC has spent over $760mm and BDI has spent over $160mm. We estimate that WSC is the largest player with an estimated 23% market share, while MGRC and BDI have 7% and 3%, respectively. The consolidation has benefited all industry players as it has brought pricing discipline to the industry and allowed players to grow their monthly rental rates faster than historical inflation rates. Over the past five years, industry leader WillScot has grown monthly rental rates by +13.9% annually for WSC, versus +3.9% annually for the Consumer Price Index. Similar to United Rentals in the industrial equipment rental market, WillScot has helped to drive rational pricing in the industry due to consolidation and the use of company-wide pricing software. Furthermore, WillScot has also touted and aggressively driven pricing through its Value Added Products and Services (VAPS) offering, which outfits boxes with convenient add-ons such as stairs, railings, furniture, and kitchen supplies. According to WSC Q4 2023 earnings presentation, VAPS unit economics seem very attractive as VAPS capital costs of $6k can generate close to $400 of monthly rental revenue or $4,800 a year, equating to a less than 2-year payback. The rest of the industry, including BDI is much earlier in its VAPS journey but should benefit from WillScot driving VAPS acceptance and penetration. VAPS revenue represents a meaningful growth opportunity for BDI. WSC has 30% of rental revenue coming from VAPS with a long-term target of 40%. For BDI, VAPS as % of rental revenue is only 8.7%. VAPS can represent an estimated $50mm+ of revenue upside potential, which is meaningful compared to MSS revenue of $207mm. VAPS revenue also comes at higher incremental margins and returns on capital. VAPS can help juice the overall return profile of a modular asset. According to WSC, they believe their units achieve ~3.5 year payback versus BDI at ~5 year payback. One major difference is WSC’s VAPS program. The caveat is that the VAPS potential may take more than 5 years to realize as it took WSC awhile to build up their VAPS business.

Rental Volume Drivers:

Industrials (60% MSS rental revenue exposure): Substantial investments related to infrastructure represent over $2 trillion of investments across the US Infrastructure Bills, onshoring, and clean energy should support industrial activity and serve as a long-term tailwind for modular units to be deployed as temporary “shade and shelter” solutions for industrial applications. For large-scale construction projects, scaled players like BDI are the go-to players because of sheer volume and service requirements and the consistency of modular units that are required by large corporate customers.

Government and Other (21% MSS rental revenue exposure): Given the speed of deployment and quick response time required for natural disasters and dynamic migrant housing, modular units are an answer to solve for temporary housing relief. Governments are recognizing this, and in the recent earnings calls, BDI called out homelessness and migrants as growth tailwinds.

Education (19% MSS rental revenue exposure): According to EducationWeek.Org, the average school building in America is nearly a half century old, and almost 1/3 of the nation’s public schools have at least one portable or non-permanent structure on campus. According to the EdWeek Research Center, to adequately renovate school buildings across the US would cost $85bn. The easier and lower cost solution is a modular solution that costs thousands of dollars to rent per year versus the cost and timeline to build or renovate a fixed building. School districts are typically too slow to meet the influx of new students, especially if an area experiences population growth. School construction requires the local government to raise tax revenue from their residents. It requires voting and petitioning that may or may not be approved. Raising taxes on local residents takes time, but students need to start school by September. Modular units can meet the timetable of a school semester in a cost-efficient manner that is also approved by the school board. Both BDI and MGRC have called out continued strength in education on recent earnings calls.

BDI Specific Growth Drivers:

While MGRC and WSC are USA-centric businesses, BDI is Canadian-centric. Out of 23 MSS stockyards, BDI only has 11 USA locations compared to MGRC with over 70 USA locations and WSC with over 200 locations. Given BDI’s smaller footprint in the US, any pickup of business from WSC/MGRC and tuck-in acquisitions can move the needle for BDI. WSC has called out “complementary” locations as a source of synergies within their merger presentation. The potential market share gains would apply to BDI’s US presence which is 37.4% of total revenue. If BDI can expand and pick up share in just a handful of locations (two to three), it would move the needle for BDI’s USA business. In terms of inorganic opportunity, the top three players control an estimated 1/3 of the North American market, which means the rest of the industry can still be rolled up. BDI seems to have plenty of dry powder left as its balance sheet of 1.7x of net debt to 2023 adjusted EBITDA is relatively clean and under levered when compared to 2.4X and 3.3x net leverage for MGRC and WSC, respectively.

LodgeLink (captured within the WFS segment) provides a compelling value proposition for both sides of the platform (property owners and corporate customers). From a property owner perspective, crew travel is a desirable customer base given the steady volume, longer-term length of stay, and diversification from leisure customers. Crew travel is thought to be low touch customers because they tend to not use the property facilities and are usually staying for the purposes of a night’s rest. From the corporate customers perspective, LL provides substantial cost savings for customers (corporates) in the form of reconciliation of various bills (back office administrative savings using LL technology), dynamic travel changes due to changing workforce roster that would have resulted in lost hotel nights if booked through other platforms like Expedia and LL offers 30-day favorable payment terms (LL pays hotel first and then gets paid by customer within 30 days). In short, LL not only allows customers to search, book and manage their crew travel, but LL is also a payment and reporting service provider that sends a reconciled consolidated invoice to the customer and allows corporations to track and change their crew travel by project. Using the “cost savings calculator” found on the LL website, a corporation spending $750k on accommodations and administrative expenses could save $240k or 32% of spending. LL charging a 13% take rate per dollar of travel booking translates to $65k paid to LL, but customers save $240k (mostly coming from administrative cost). Given the seemingly compelling value proposition and TAM, the company has lofty long-term ambitions of $100mm of net revenue. Assuming LL can get to $30mm of net revenue and assigning a 6x revenue multiple for a fast-growing digital platform with a sizable TAM of $70bn gross bookings, LL could be worth $180mm in a couple of years. This would represent 1/3 of BDI’s current market cap.

Risk and Mitigant:

Although there are positive industrial tailwinds, BDI is a cyclical business. However, what is interesting about the modular/storage business is its ability to generate substantial cash in a downturn because growth capex can be turned off and the rental assets are sticky. As mentioned above, there are a lot of associated costs for the customer to return assets. Ostensibly, it may be “cheaper to keep paying the rent” for a couple of months versus paying for return fees and usage related damages as the customer is liable to return the unit back to its original condition. Studying MGRC and Mobile Mini (before Mobile Mini was acquired by WSC) during the 2008 – 2009 Great Financial Crisis period illustrates the strong FCF generation capability that is masked by growth capex when times are good. In 2008, MGRC generated $18.7mm of FCF (cash from operations minus capex) or 13% conversion of consolidated EBITDA, which jumped to $79mm or 62% conversion of consolidated EBITDA in 2009. This massive FCF jump for MGRC was despite a 12.8% drop in rental and rental related services revenue. A similar pattern occurred for Mobile Mini. Mobile Mini generated $33.9mm of FCF in 2008 or 25% conversion of consolidated EBITDA, which jumped to $89.7mm of FCF or 62% conversion of consolidated EBITDA. This massive FCF jump for Mobile Mini was despite a 10.2% decline in rental and rental related services revenue. In short, investors can “sleep well” holding a cyclical compounder through the cycle as the business is grounded on strong FCF generation in a downturn.

In the short term, there is a possibility that the WillScot and McGrath merger could be blocked by the FTC. On February 21, 2024, WSC and MGRC received a “Second Request” from the Federal Trade Commission. WSC would need to provide additional documentation to comply with FTC’s requests. The mitigant is that our 2025E numbers do not include upside from the merger. Moreover, the extended merger process could benefit BDI in terms of inorganic opportunities as two of the largest acquisitors within the industry are seemingly handcuffed from doing deals for the time being. On the Q1 2024 earnings call, CEO Trevor Haynes said: “Our M&A pipeline is increasingly active, and while we cannot predict timing or certainty with respect to deals, we have historically supplemented our ongoing growth with the good tuck-in acquisitions along the way. And that will very much remain a part of our playbook going forward.”

Upside/Valuation:

BDI is a relatively undiscovered long-term compounder as it rents out long lived assets with minimal maintenance capex that generate healthy returns on capital over multi-year rental terms. There are multiple ways to win: 1) a combination of solid industry fundamentals, BDI share gains, and pricing/VAPS penetration drive low-double digit EBITDA growth 2) multiple expansion from an undemanding 6x 2025E EBITDA to closer to 8x to 10x 3) LodgeLink scales, breaks even, and is then potentially monetized. At the September 2023 Investor Day, management has talked about taking on a venture/growth investor when appropriate. 4) The WSC/MGRC merger causes some customers and employees to turn to BDI.

Buyers of BDI stock can generate ~20% IRRs over the next few years barring a cyclical downturn. Even in a downturn, modular businesses can turn off growth capex, run maintenance capex and stand to convert ~60% of EBITDA to FCF. BDI stands to generate $100mm of EBITDA in 2024E. If a modest recession were to occur and BDI’s EBITDA were to be down ~10% or $90mm of EBITDA, then BDI could generate $54mm of FCF in a downturn (60% conversion). With BDI’s market cap at $500mm, $54mm of FCF would represent 10% FCF yield through a downturn. This seems compelling for a long-term, high-quality compounder.

DISCLAIMER: Any discussion herein of specific investment ideas are provided only to illustrate the author’s investment methodology and are presented for informational purposes only. Opinions expressed herein are not an investment recommendation and are not meant to be relied upon by you in making investment decisions. The author’s opinions expressed herein address only select aspects of a potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is limited in scope, based on an incomplete set of information, and has limitations to its accuracy. Furthermore, the author may not issue updates with respect to its opinions about any securities mentioned herein. Prior to making an investment in any security, the author recommends that potential and existing investors conduct thorough investment research on their own. Any opinions or estimates constitute the author’s best judgment as of the date of publication and are subject to change without notice. 

Certain information contained in this report is derived from sources believed to be reliable. However, the Author does not guarantee the accuracy, completeness, or timeliness of such information and assumes no liability for any resulting damages. Due to the ever-changing nature of markets, the deductions, interrelationships, and conclusions drawn from historical data may not hold true in the future.

Catalyst

-Strong rebound in growth and margins in 2025

-Continued shift away from WFS to growing MSS

-LodgeLink scales and achieves break even

-Acceleration of shares gains/performance as a result of MGRC/WSC merger

-Monetization of LodgeLink