Description

I am submitting this post for membership reactiviation purposes. This was one of the memos that I wrote earlier this year where the catalysts were realized. I wanted to submit this as an example of my go-forward memo creation. 

1/16/2024

DXP Enterprises Inc. (Ticker: DXPE) “Red Team” Investment Memo

Current Share Price: $31.28

DXP Enterprises, Inc (“DXPE” or “Company”) offers a unique opportunity to invest in a leading provider of MRO products undergoing meaningful business transformation that the market is not valuing appropriately. Additionally, there are potential near-term catalysts through M&A, a recent debt refinancing, and movement into higher gross margin product categories, that could crystalize value.

The Company is currently trading at a conservative valuation (8.7x P/E versus 22.7x and 31.0x for their largest competitors, Grainger and Fastenal respectively), likely from the 2022 lackluster performance, lower margin profile, and oil and gas exposure.

Since 2022, the Company has invested meaningfully in corporate overhead, accelerating revenue growth, and has had a ~200bps improvement in Adj. EBITDA margin despite the reinvestment. While the stock has improved marginally (~10% since 2022), the clear transition of the business warrants a stronger valuation, providing an opportunity to crystallize potential short-term value and limiting long-term downside risk. Base Case returns do not factor in short term value crystallization and provide a view of a conservative 3-year investment.

The Base Case forecasts the Company reaching $71 per share, returning a 2.3x MOIC or 32% IRR, assuming an exit in 2026E (~3-year hold) using conversative assumptions.

What You Have to Believe (WYHTB)

·         Maintains current operating performance in their core Service Center segment

·         Continues to penetrate of higher margin IPS markets

·         Executes $5M of acquired EBITDA annually and has a strong M&A pipeline

·         The Company has made the bulk of their corporate overhead investments in 2023E and has ample operating leverage for the next 2-3 years

A) Company Overview

DXPE is a leading distributor of industrial products and services, headquartered in Houston, Texas. Founded in 1908, the company provides maintenance, repair, and operating (MRO) products, equipment, and integrated services. The Company has over 25,000+ active customers across various end-markets, including oil and gas, general industrial, food and beverage, transportation, chemicals, and water and wastewater. The Company exclusively serves North America, with 95% of revenue generated in the US and 5% in Canada.

Historically, the Company has largely served the oil and gas markets but has made a concentrated effort to derisk exposure by entering new markets. Today, DXPE only has ~30% of revenues generated in oil and gas with the remainder in other industries.

The Company has had a history of stable organic growth, ranging between high-single digits to mid-teens, and executing strategic M&A to enter new product markets and build further capacity. Since 2020, the Company has executed 16 acquisitions and grown at a ~20% Revenue CAGR (~10% Organic Revenue Growth CAGR) and ~45% Adj. EBITDA CAGR. 

Business Overview (FY 2022; Metrics are 3Q23 LTM)

1) Business Segments

DXPE operates in three core operating segments: Service Centers, Innovative Pumping Solutions, and Supply Chain Services.

·         Service Centers (69% LTM Revenue): core business providing MRO products, equipment, and services to customers.

o   The Company currently has 157 service centers and 4 distribution centers across the US.

o   Offers same day delivery, a key differentiator, and is a Tier 1 distributor that can purchase products directly from manufacturers. This dynamic allows the Company to deliver premium services at discounted costs to their customers.  

o   The Company is a Tier 1 distributor of over 1M items, allowing the Company to service almost all customer MRO needs.

·         Innovative Pumping Solutions (“IPS”) (15% LTM Revenue): provides integrated, custom pump skid packages, pump remanufacturing and manufactures branded private label pumps to customers. The Company currently has 16 fabrication facilities across the US.

o   IPS segment acts as a single source of design, engineering, project management, and systems design and fabrication for customers, simplifying supply chain needs.

o   The Company leverages its MRO product inventories and authorized products to lower total costs to customers and maintain quality of pump packages.

o   The Company has over 100 years of fabrication experience, creating significant technical expertise that acts as a competitive moat. 

·         Supply Chain Services (“SCS”) (16% LTM Revenue): fully outsourced MRO services, with the Company managing all or part of its customers’ supply chain, including procurement and inventory management through long-term contracts with customers.

o   The Company has developed proprietary assessment tools and master templates to take cost out of supply chain processes and streamline operations.

o   The Company is integrated into 95 customer facilities.

2) Recent Updates and Near-Term Catalysts

Debt Refinancing

The Company recently refinanced its Term Loan B ($550M), reducing their borrowing cost by ~50bps from S+525 down to S+475. The refinancing will provide $2.75M of interest savings before any debt issuance and financing cost amortization.

In conjunction, the Company raised an incremental $125M in capital, signaling support of continued M&A in the near term. This is substantiated by Kent Yee (CFO) commenting on continued M&A activity in the 3Q23 earnings call. Based on the commentary, there will likely be 1-2 acquisitions announced in 1H24 which should provide meaningful uplift in the stock based on past reactions to M&A in the stock (please see annotated stock chart for reference). 

Working Capital and Backlog

The Company has experienced meaningful net working capital benefits, driving better free cash flow generation, and has experienced significant tailwinds in their IPS backlog, substantiating 2024E IPS performance and potential margin increases.

The Company has been building inventory volumes over the course of the year and is starting to offload their inventory. This is paired with the Company unwinding their accounts receivable. This has resulted in a ~$18M positive free cash flow impact in 3Q23. The Company is expected to continue to unwind their inventory as they perform against the IPS segment backlog, which will provide a short-term free cash flow benefit (~$105M of inventory / ~$77M Finished Goods / ~$27M WIP).

The IPS segment has performed well, with its best performance since 2015. This has been driven by ~8% growth in the core oil and gas segment, but importantly has experienced material tailwinds in new markets, notably a ~27% increase in water and wastewater. With their sales momentum, the Company has created a significant backlog (~3x 2022 backlog) with ~$40M net profitability (~30% contribution margin versus ~14% Dec-22 contribution margin). The higher margin products should continue accelerating as there are proof points of the Company penetrating new adjacencies and reinvestment in their sales force.

Acquisitions

The Company recently closed its acquisition of Alliance Pumps, a small pump add-on, and closed 2 other deals in 2023. All three of these deals are currently undergoing integration and should experience margin pickup based on management commentary in 3Q23 earnings call.

Additionally, the Company has relevered through their Term Loan B refinancing and added an incremental $125M of excess leverage capacity. Based on management commentary, they have a strong M&A pipeline that is highly actionable. Assuming a 7x add-on acquisition purchase multiple, the $125M of excess debt capacity implies ~$18M of incremental EBITDA acquisition capacity (assuming all cash deals). $18M of incremental EBITDA has 120% coverage of the total Base Case acquired EBITDA through the hold period, providing ample cushion to the Base Case assumption.

B) Investment Thesis

·         Core Service Center Business is Entrenched: the Company has a strong niche in rotating equipment and cutting tools, which make up ~70% revenue. Both are non-discretionary items to their end markets, making it a sticky product.

o   Reinvestment in the sales force should support top-line growth in-line with historical performance with potential upside

·         Continued Improvement in Cost Realization: the Company has purposefully overinvested in SG&A, largely in sales, providing operating leverage for the Company while supporting top-line. The Company should have minimal SG&A reinvestment in 2024E as the Company grows into their expense base.

o   Additionally, the Company is digesting 3 add-on acquisitions which should provide margin EBITDA margin improvements as synergies are realized.

·         IPS Segment Continues Current Momentum: the Company will continue to penetrate higher margin markets and projects in their IPS segment, driving contribution margin closer to the high-20s, providing meaningful lift in segment operating margin.

·         Significant M&A: there are ample M&A opportunities for the Company to execute in the short term and put the incremental $125M of excess leverage to work.

‘Hadrian Wall’ Growth Criteria

C) Market Overview

Market Sizing and Competitive Landscape

The broader MRO market is massive at a ~$431BN TAM. The size of the market has created a highly fragmented landscape, with several large regional and local MRO distributors across a variety of markets. The market is expected to grow about in line with US GDP (3%-5%), with a few tailwinds that could accelerate growth marginally.

The strongest tailwind for the broader MRO market is the market refocusing on asset lifecycle and predictive maintenance. As manufacturers and operators take a wholistic approach to asset lifecycle management, there is a broader emphasis on maintaining instead of replacing assets. This is accentuated by the predictive maintenance trend. As companies focus on maintaining assets, there will be a larger investment in maintenance parts which will increase MRO spend.

The fragmented nature of the market means there is no incumbent or deeply entrenched player, however there are large players in the market that are direct competitors to DXPE. Core competitors include: Grainger ($43BN MKT Cap), Fastenal ($36BN MKT Cap), OTC, and Applied Maintenance Supplies & Solutions. While competitive, Grainger and Fastenal largely focus on areas outside of DXPE’s core competencies. Fastenal is more focused around safety equipment and fasteners, and Grainger focuses more on high-touch solutions. OTC and Applied are more specialized MRO providers, providing customized solutions. 

While MRO is largely commoditized, DXPE can differentiate through their product specialties (#1 rotating equipment provider, top 5 cutting and safety tools provider), and end market focus. Regarding regional players, DXPE can leverage their scale and Tier 1 distributor status to compete on price, product / inventory availability, and same day delivery. 

D) Operating Model and Returns

Below outlines the Base Case operating model for DXPE, with a fulsome model including returns build provided in the data pack sent in conjunction with this memo. Note that historical financials (2021 and 2022) are non-pro forma for acquisitions, artificially raising historical growth rates.

Key assumptions for the model are:

·         Forecasted growth and operating profit for 2023E in-line with 9M23 YoY growth and operating profit

·         Service Center and SCS 2024E – 2027E revenue growth in-line with 2022 organic growth

·         IPS 2024E revenue growth experiences a slight uptick based on current backlog, and blends down to run-rate growth of ~15% thereafter

·         Service Center Operating Profit Margin expands ~50bps annually, driven by economies of scale and mild pricing

·         IPS Operating Profit Margin experiences ~5% expansion from 2023E – 2027E, driven by gross margin improvement, as the Company continues to penetrate higher margin verticals

·         Corporate Overhead has significant growth in 2023E, as the Company reinvested in sales and organization (in-line with 9M23 YoY growth)

·         The Company acquires $5M EBITDA at 10% EBITDA margins annually for 7.0x EV / EBITDA multiples

o   Acquisitions grow revenue 10% YoY and expand EBITDA margins 1.5% YoY

o   Acquisitions assume the Company maintains 5.0x Debt / EBITDA and 75% purchase price amortization

·         Returns assume no-share buy-backs and all excess FCF generation is put towards acquisitions or held on the balance sheet

Enterprise Value Sensitivities (2026E)            

Share Price Sensitivities (2026E)

E) Value Realization Catalysts

Compared to other ‘Hadrian Red Team’ memos, the Company has few value realization catalysts. However, the stable operating performance and clear improvement in Company performance in 2023 accentuates the impact that the value realization catalysts should have on the stock. These should be viewed as pure upside levers, with the base case being attainable outside of the catalysts below:

·         Continued EBITDA margin improvement

o   Gross margin improvement driven by IPS - medium

o   Operating leverage realization (largely sales staff) - medium

o   Acquisition integration margin uplift – medium

o   Pricing increases / inflation passthrough – low

·         Acquisition acceleration

o   Near-term tuck-in acquisition pipeline realization – high

o   Near-term transformational M&A – medium / low

·         Share Repurchases

o   Lack of capex needs allows the Company to reinvest capital through share repurchase, as shown by 2023 capital use highlighted in the Appendix – medium  

·         Valuation rerating

o   Company gets rerated based on EBITDA margin improvement, cyclicality derisking, and stronger revenue growth – low / medium  

F) Risks and Mitigants

·         Cyclicality – exposed to both asset lifecycle cyclicality and end market cyclicality (oil and gas)

o   The Company has derisked from oil and gas to only ~30%

o   The Company serves over 25K customers, mitigating single customer asset lifecycle risk

o   The Company has undergone several broad economic cycles, and refocused the Company towards cash generation during those period (highlighted in Appendix)

·         Free Cash Flow Generation – capital intensive nature reduces free cash flow generation capacity

o   At its worst (2022), the Company generated 2% FCF conversion, this was when the Company was unwinding the supply chain backlog and reinvesting in the business

o   Base Case assumes mild FCF conversion of 10%, a 10% cushion to current pace

·         Competitive Landscape / Differentiation – product is commoditized and competes against large national players

o   The Company is deeply entrenched in rotating equipment (58% of revenue) which is a less commoditized product than other segments (e.g. piping)

o   Larger players are skewed towards higher-touch / higher-margin products, giving DXPE a nice niche in the low-margin product space 

·         Macro Factors – supply chain risk, inflation, and higher interest rates

o   The Company combatted supply chain disruption in 2021 – 2022 through focusing on on-shore manufacturers and leveraging their Tier 1 distributor status to get preferential deliveries

o   As a distributor, the Company is able to pass through inflation related price increases

o   The Company is reasonably levered at <5.0x Net Debt / LTM EBITDA

G) Appendix

Historical End Market Transformation

EBITDA Margin Uplift by Quarter

Product Divisions Overview

Free Cash Flow Conversion

Capital Allocation

Catalyst

M&A

Pipeline Realization

Cashflow generation and continued share buybacks