Description

Open ended secular growth with sustainable competitive advantages at a reasonable valuation.  We believe the stock is a multi-bagger over the next few years and our DCF indicates that the stock should be 150% higher today. 

DRT is a C$550 million market cap company based in Calgary, Canada.  It also has over C$80 million of net cash.  The company is revolutionizing the interior construction industry through technology and customizable prefabricated building interiors.  Customers such as Google Inc. and Netflix Inc. have used DRT’s software to design their newest offices.  The software provides users with a 3D interface to build and create a made-to-order interior project.  It also provides real-time estimation of costs as the design changes.  In turn, the software provides a link to DRT’s manufacturing facilities where components are custom built to fit specific customer requirements.  Construction is normally completed in 3-4x less time than traditional construction at about the same total cost.  Moreover, the customer has peace of mind in knowing that cost overruns are extremely unlikely.  Construction with DRT is also more environmentally friendly than traditional interior construction and allows for much more flexibility and easier maintenance.  For example, if your glass door breaks, just order that part again.  If you want to change your transparent glass wall in your conference room to a translucent one, just order a new wall and swap it out.  The company has an enormous addressable market.  It is currently offering products for commercial construction but plans to enter the residential market next year.  Watch the short video on the top of the company’s home page to get an idea of what they do: http://www.dirtt.net/ .  The company currently gives away its software and makes money on the building materials.  It is also exploring ways to monetize the software separately. 

The company was founded in 2006 and the initial venture investors were probably somewhat disappointed in initial growth.  The company was offering a revolutionary product and had to go up against very established ways of doing business.  Nevertheless, our channel checks indicate that market adoption got to a tipping point towards the end of last year.  This was also confirmed by the company’s revenue growth.   Year-over-year revenue growth accelerated from 10% in Q2 2014 to 27% in Q3 2014 and then to 69% in q4 2014.  Q4 2014 benefited from recognition of a large project.  Revenue growth in the 1^st half of 2015 has stayed relatively high.  Q1 2015 and q2 2015 y/y revenue growth was 40% and 25%, respectively.  We have talked to about 20 distribution partners and end customers and feedback of the product has been universally positive.  At first, general contractors dismissed it because they had set relationships in place for building materials.  Our checks indicated that the ones that did use DRT become hooked.  While the GC’s may get less revenue per project when using DRT, this is more than offset by increased volume of business and improved margins.  They can do a lot more projects because of the efficiency of DRT’s product.  In addition, they can differentiate vs competitors by offering higher customization, significantly faster timelines and environmental friendly construction.  Many of DRT’s distribution partners are office furniture companies.  They also love DRT because it gives them the chance to get a portion of the interior construction business.  DRT normally shares about 20% of the gross revenue from a project with its distribution partners.  DRT also allows these furniture companies to develop a stronger relationship with their end customers.  In the example above of a glass wall breaking, the customer would contact its distribution partner to get a replacement wall from DRT.  This contact allows the distribution partner a chance to come in and sell other things like new furniture to the customer. 

The company does not currently appear to have any meaningful competition.  Furniture and building materials companies do not have the necessary technical expertise and software companies do not have competency in manufacturing building materials.  Furthermore, the company’s customers and distribution partners do not want to learn to use software from multiple vendors.  As more distribution partners, architects and general contractors spend time to learn how to use DRT’s software, they are unlikely to bother learning how to use a product from someone else.  There is a natural network effect to this business that should create a winner-take-all dynamic.  The company has invested over C$50 million in its core software and product development.  It has 100 patents and another 151 patents pending. 

The stock is mainly followed by a handful of Canadian building materials analysts at boutique banks.  We believe that the company will look to list in the US in the next 12-24 months.  Over 80% of revenue is generated outside of Canada.  Such a listing could be the catalyst for increased research coverage by US based technology analysts and could cause a shareholder transition towards growth or momentum investors in the US. 

At its recent analyst day, the company shared its 3 year business plan.  In 2018, management is looking to generate C$350 million of revenue vs 2015 consensus of $C232 million.  Management is also targeting 2018 ebitda margins of 25% vs about 13% in 2015.  If the company gets anywhere close to these numbers, the stock should be much higher.  These numbers imply 87.5 million of ebitda in 2018.  Even at a conservative 12x multiple, the stock would be more than a double.  The business is not very capital intensive (capex and depreciation are at about 6% of sales) and the company currently has enough capacity in place to reach its 2018 targets. 

In our DCF, we use 20% long term revenue growth and get to a C$1 billion of revenue in about 8 years.  We use a long term 24% ebitda margin in the terminal year vs management’s 3 year margin target of 25%.  This yields FCF per share of over $1.60 in 8 years.  Discounting cash flow at 14% and using an 18x terminal multiple yields over 150% upside to today’s price.  We think C$2 per share in EPS 4-5 years out is a realistic upside scenario.  Companies with open ended secular growth like this and sustainable competitive advantages usually trade at very high multiples of revenue and current earnings.  At about 2x 2015 sales and 19.5x 2016 consensus EPS ex cash, the stock doesn’t not seem to be very reasonable priced for its potential. 

Top management have most of their net worth in the stock and the company’s President recently bought shares in the open market.  See:  http://www.dakotafinancialnews.com/insider-buying-dirtt-environmental-solutions-director-acquires-7000-shares-of-stock-drt/341244/  . 

With respect to the very short term, management seemed to project a very positive tone with respect to current business conditions at its recent analyst day.  They should also benefit from the weak Canadian dollar (80%+ of revenue outside of Canada but a majority of costs in US$) as well as weak Aluminum pricing (Aluminum is a high teens percent of COGS).  The company does have a tougher compare in q4, however.  The business can be lumpy as projects can always be delayed or cancelled.  Given the company’s short lead times, it doesn’t have a lot of visibility.  Linearity in the quarter also impacts gross margins since the company does not build much finished goods inventory as all orders are for custom projects.  For example, gross margins in q1 2015 were negatively impacted by weather disruptions in the Northeast.  It is better for the company’s quarterly gross profit to run its factories at a uniform utilization over the quarter than to have one month’s utilization low and another month’s utilization very high.  The company is expecting to recognize about C$8m of revenue from a large project with ConocoPhillips in Houston in 2016.  Weak energy prices could potentially impact its recognition.  We think this is one you just buy and put away for at least 3 years.    

Catalyst

potential short term upside to earnings.

Listing in the US.