Description

The fifth time is a charm? Dirtt is a small cap value stock, and we know how well these have done the past few years. Dirtt has been written up on VIC four times, with the last time being in early 2020, unfortunate timing due to Covid. The company is transformed since then, and the TEV is a fraction of its former levels. Dirtt has a colorful history that I will summarize, but it is helpful to review the past write-ups.

Dirtt is an innovative interior prefab construction company that produces custom, high-end, easily-installed, smartly designed walls/doors/etc for office and medical spaces mainly in U.S./Canada. On the front-end, they have a design software product that lays out the floorplan and from that floorplan, lists the specific, custom items to purchase from Dirtt. Their sales pitch is the ease-of-design, speed-of-completion, ease-of-install and a lower total cost of construction for a classy, high-end office.

There are many office space companies, but very few offer (1) high-end; (2) custom; (3) architectural (not cubicles or standing partitions); (4) adaptable; (5) prefab solutions. The office market is dominated by the traditional on-site trade solution: frame, drywall, etc. Much of their business has come from repeat customers as they use them for small remodels and small build-outs.

They serve the commercial office/education/healthcare/public sectors, but the commercial office business remains the most important despite their efforts to diversify. A simple model of commercial projects are (1) large buildouts where GCs bid for the work (e.g., Chase takes over ten raw floors) versus (2) small remodels or build-outs (e.g., Chase remodels half a floor). Thus far, Dirtt has only served #2 projects and has not yet sought to get designed into large build outs via large GCs. The current sales model is not ideal for getting designed into large GC projects. The bull case does not rely on winning #1 projects, but that would be an additional driver.

COVID dramatically affected Dirtt's prospects. However, due to their focus on small remodels, the demand has not been affected as much as one might expect. As businesses re-structure their office use post Covid, there remain remodels and small build-outs.

After a disastrous 2021/2022 and a change of management, the company has found its footing and trades at an attractive valuation. The current management team has engineered an extraordinary cost cutting program while growing revenue. Overhead headcount has been cut by 30%. Manufacturing facilities have been consolidated to reduce excess capacity. And operating margins have gone from deep in the red to in the black despite continuing CRE headwinds.

58% of the stock is held by two small-cap value funds (22NW LP (Aron English) and WWT Opportunity (Shaun Noll)), which have been owners since 2020. And they also hold the majority of the debt. Both sit on the Board of Directors.

History
The history of Dirtt can be divided into three time periods.

Mogan Smed (founding through 2017) -- Smed is the classic promotor entrepreneur, both positive and negative. He started the company, found success, but had no business running a scaling publicly-traded company. He built himself a house with company funds! He was relieved of his CEO duties in Jan 2018, but he stayed on as Head of Sales until Sept 2018. This was not a good idea as he used his remaining time to steal the sales pipeline for his new, competing company (Falkbuilt).

Kevin O'Meara (2018 - 2022) -- O'Meara was dealt a tough hand and then made it far worse. Due to the turmoil surrounding Smed, the sales pipeline was dry by 2019 and revenue dropped. And then COVID struck. O'Meara refused to recognize the new reality and would not make the necessary cost cuts to save the business. He kept running the business as though volumes would bounce back quickly and it would be 2018 again. The previously profitable business was bleeding large amounts of cash and running off a cliff. The balance sheet became highly levered after a large convert offering was required to raise cash.

Ben Urban (2022 - current) -- The two funds (esp 22NW LP) took over the Board and hired Urban. Urban was the largest Construction Partner (effectively 3rd party sales), and has demonstrated a strong understanding of the operations and finances.

Urban has orchestrated one of the more impressive turnarounds I have seen. The April 2024 presentation does a good job detailing the changes that were made to deal with the new reality. They fall into a few major buckets:

- Overhead (SG&A) Headcount was slashed by 30%. Headcount went from 401 to 282. Internal sales reps went from 65 at the end of 2021 to 39 at the end of 2023. Tech and Dev employees went from 100 to 73.

- Pricing was revised. Urban bit the bullet and raised pricing significantly and turned down low margin projects. Volume initially dropped as expected, but as they lap the new pricing, volumes are rising.

- Excess manufacturing has been closed.

And while doing this cost cutting, he has grown revenue and improved manufacturing error metrics. The pricing and cost structure he inherited was doomed in the new reality, and he did what was needed to get it in line.

Further, Urban bit the bullet and right-sized the balance sheet via a massively dilutive rights offering (shares outstanding almost doubled) in Jan 2024. As well, Dirtt purchased some of its debt at 70 cents on the dollar. And net debt is now less than $10mm.

Smed started Falkbuilt while still employed at Dirtt or shortly thereafter. It is attempting to become a carbon copy of Dirtt, and he certainly violated the terms of his contract/severance from Dirtt. The resulting lawsuit has been ongoing for years. Our legal system is what it is, and despite the clear fact pattern, I have no idea how this will turn out.

So now, we have a small cap that checks all the boxes:
1) Solid management team for a company this size. And an aligned Board with skin in the game.
2) Right-sized balance sheet
3) An innovative, proven product that for smaller projects (and possibly larger projects) (i) shortens time from start to finished construction; (ii) lowers total time of construction; and (iii) lowers total cost of construction due to fewer hours of labor on site.
4) Reasonable valuation with operating leverage upside
5) Huge TAM. Long runway of growth if the Dirtt solution continues to prove itself versus tradition on-site construction
6) 20+% ROIC
7) Two controlling shareholders on the Board
8) Limited direct competition
9) Positioned for strong operating leverage as they grow volumes
10) Small cap funds have been burned here so leery of reboot.

The high growth expectations (see previous Dirtt write-ups) from pre-Covid are gone for the time being. Dirtt revenue is not going to grow revenue at 25% CAGR, but at this valuation, they do not need to grow at that rate. Dirtt is well-positioned to capture the remodels and small build-outs that will inevitably be a large part of office downsizing and transitioning.

VALUATION

Shrs (fully diluted): 195mm * C$0.64 = C$125mm = US$90mm
Net Debt = $8mm
TEV = $98mm

They have ample NOLs from the past 5 years and will not be paying taxes for a decade.
Forecast:
Rev '24 = $195mm
EBITDA = $15mm
SBC = ($3mm)
Capex = ($3mm)
Unlevered FCF = $9mm (11x)
ROIC will be about 20-25% this year, and incremental ROIC will be significantly higher.

There is a long runway of 5-10% volume growth plus a lot of operational leverage. This is expected to be a long-term holding, and I do not expect a quick multiple re-rating, but in terms of fair value, it should trade 15-20x.

RISING VOLUMES and OTHER ENCOURAGING SIGNS

As I mentioned above, Dirtt raised prices dramatically to deal with inflation. Their major costs are aluminum, glass, and labor. The price increases were:

+6.5% in November 2021
+5.0% in June 2022
+10.0% in July 2022.

Physical volumes dropped hard after the price increases. However, what has attracted me to this investment is the past 3 quarters (having lapped the price jumps) of volume growth.

Y-O-Y Volume Increases
Q3 '23: +3% (note: Q3 '22 had some sales at lower prices so this quarter does not fully reveal lapping of price jumps)
Q4 '23: +20%
Q1 '24: +11%

As well, the announced pipeline has been stable.

Dirtt sells predominantly via Construction Partners. The number of CPs topped out in 2019 and dropped significantly in 2020-2022. Since then it has stabilized and rebounded.

Construction Partners (end of year):
2019: 87
2020: 72
2021: 69
2022: 67
2023: 72
Q1'24: 74

COMPETITION

Dirtt is unique in offering a full-product suite of prefab, high-end, architectural, modular/adaptable, custom solutions. The front-end software product (built with AWI flooring) is another differentiator. And finally, they have built up a reasonably dense network of local resellers (i.e. 74 Construction Partners). Dirtt has four "Experience" Showrooms in the U.S. to demonstrate the full range of possibilities with their products.  

There are alternative pre-fab solutions: pods/cubicles, free-standing dividing walls, etc. But these are not architectural and not customize-able and look down-market.

There are some startups (e.g., Juunoo, Falkbuilt) who have an incomplete product line and without the network of local resellers.

There are larger companies (Steelcase, Teknion, Haworth, and Allsteel) who have some of the same product offering. In my mind, these are the largest threats if they decide to focus on the office construction (it is currently a tiny piece of their business as they are focused on office furniture) and build out a reseller network focused on construction. Their current dealer networks are focused on selling chairs, desks, and file cabinets, not construction.

In the medium term, direct competitors are probably not the main issue though as this is an enormous TAM that is dominated by traditional on-site construction. There is plenty of room to grow so long as the prefab solution can continue to compete versus traditional on-site construction.

RISKS

1) Aluminum and Glass inflation. Versus traditional on-site construction, Dirtt is short Aluminum/Glass and long lumber/drywall/labor costs. In the Q1 press release, there was a warning about rising aluminum prices, but aluminum has dropped sharply to 2023 levels since then. Glass prices rose sharply in 2022 and peaked in Q4'22, but they have dropped since Q4'22. It is possible that the sharp rise in aluminum costs during late Q1 and through Q2 will hit Q2 margins slightly, but this should be a one quarter effect.

2) Worse CRE headwinds. Things can always get worse even after they begin to improve. But again, Dirtt's focus is on remodels and small build outs, and this market is less vulnerable to general CRE headwinds.

3) Takeunder. More specifically, a small premium takeover by the controlling shareholders.

4) Sales are lumpy quarter-to-quarter as single projects can be several percent of sales. This evens out over a year, but stock can be volatile around earnings due to lumpiness and lack of liquidity. 

Catalyst

Admittedly Weak. This is not an event-driven investment.

On the macro side, a continuation of the small-cap value rally we have seen in July.

The real catalyst to a multiple re-rating is continued growth and the operational leverage I expect with continued growth.