Description

To put it crudely, Dycom (DY) is a company providing commodity services (essentially digging ditches and laying cables for telecom companies) that seems to be operating at near peak margins (and having seen its stock price double over the past year), despite not having generated any free cash flow over the last 5 years.

Quality of business: DY provides engineering and construction services primarily for the telco space. By its own description, there are “few barriers to entry”, “pricing matters”, and it also has a quite concentrated customer base, with five customers representing 61% of revenues (AT&T alone representing 21%), characteristics which would certainly make Porter somewhat uncomfortable.   

So what caused the very strong surge in the stock? DY has benefited from a surge in spending related to 1-Gigabit deployment of fiber to the premise (or specifically into the home), ie : 1G FTTx.  AT&T has a target of upgrading 12m homes over the next 4 years, and CenturyLink (DY’s second biggest customer, at over 14% of revenues) being an early mover in the upgrade cycle. Other well capitalized players such as Google can certainly add fuel to this capex wave in the industry.

In addition, the Connect America Fund, which is an FCC program providing subsidies for carriers to invest in broadband expansion for certain underserved areas, could be another tailwind to revenues.

While certainly a risk on the upside, we believe that this is somewhat reflected in the price.  In the prior five years, DY’s EBITDA margin was under 10% on average, yet in its F2015 (July), the margin was 12.4%, or over one standard deviation higher than its prior 5-yr and 10-yr averages. Consensus, on a calendar year basis, assumes that revenues continue to ramp (growing close to 18% y/y, acquisitions included – note that on an organic basis, the growth for the last fiscal year was under 10%), and more impressively, EBITDA margin reaches 14.2%.  In DY’s entire history, going back to the early 90s as a publicly listed company, it has only achieved a similar margin in F2004 (benefiting from the ramp in Verizon’s Fios) and during the tech bubble in F1999-F2001 (when it achieved a peak margin of over 17%).

Valuation: if we assume DY can operate at 13.5% EBITDA margin and that it can trade at 8x EBITDA (which is one standard deviation higher than the average multiple over the past 3 years, and higher than one standard deviation over the past 5 and 7 years), we would get a stock price of $69, which essentially is in line with the current price of $70.

C2016 consensus revenues: $2.64bn (+17.9% y/y)

EBITDA: $356mm

EV (at 8x): $2.85bn

Net debt: $620mm (2.15x LTM EBITDA)

Shares: 32.481mm

Implied price: $69

If we give DY the benefit of the doubt and value it off peak margins and peak multiples (almost 10x EBITDA, which was the high over the prior 7 years), we would get a price in the low 90s, close to where the stock peaked just in the beginning of December, and which proved to be a very compelling entry point. 

However, what we found even more interesting is that despite this ramp in business and margins, the business has proved to be capital intensive: capex has been ramping (to accommodate new work) and so has DSOs (having increased by 10 days over the past 5 years to the low 50s).  If we include sale and acquisitions of businesses, which seem to be fairly recurring, we can see how DY has had a cumulative cash deficit over the past 5 fiscal years:

=>cumulative free cash flow: -$302mm

For the LTM period, the pattern continues:

(Look at slide 17 from the company’s last IR presentation: http://www.sec.gov/Archives/edgar/data/67215/000006721515000051/investorpresentationdece.htm

Notice how over a 10+ year period, capex plus acquisitions exceeded cash flow from operations, and DY had to resort to other sources of financing, such as borrowings, to cover the shortfall and fund share repurchases.)

How much should we pay for a company operating in a somewhat commoditized business, at close to peak margins, with no cash flow generation?

DY lists as comps Mastec, MYR Group, Willbros and Quanta.  We are not sure some of those are ideal comps, due to different end market exposure, with Willbros being more exposed to the depressed oil and gas, and MYR to the transmission and distribution space.  If we include other E&C companies such as Jacobs, KBR, and Fluor, we note that historically they had very similar operating margins as DY, in the 4-5% range, but none have benefitted as DY has in terms of margin ramp over the past 12-18 months. This larger peer group has historically traded around 6x EBITDA, which is in line with DY’s historical multiple (6.5x 5-yr average and 5.7x 7-yr average).

C2016 consensus revenues: $2.64bn

EBITDA: $264mm (10% margin, slightly higher than prior 5 and 10 year averages)

EV (at 7x): $1.85bn (higher than historical to allow for near term supra normal earnings)

Implied price: $38

Risks:

Continued industry growth (high tide lifts all boats), leading to abnormally high margins

DY in midst of a $40mm buyback plan

Easier comps given harsh winter last year

Potential M&A target (although note that DY is the largest player in its niche by a considerable margin; while it is possible that a customer could acquire DY and bring the knowledge in-house, we question the rationale as likely they would lose the revenues from the competing customers, among other factors)

Catalyst

Competition

Reversion to the mean post spending cycle