Description

Dycom (NYSE: DY)  - Long

Investment Thesis

Dycom (NYSE: DY) is a small cap specialty contracting services company that primarily works for cable/telecom companies.  It was written up as primarily a valuation call by Teton29 in April 2010, and that write-up might be helpful to look at for background.  DY is undervalued, unloved and for the most part, undiscovered (or more accurately, forgotten).  A telecom boom darling from '97-'00 when it rose 11 fold (before crashing 80% in the subsequent 12 months), the stock has been range-bound the last decade and is still down 12% this century.  This under-performance has created an opportunity.  To start with the conclusion, I think DY can rise 80-100% in the next 18 months for a target price of $45-50 per share.  If telecom/cable gets hot again (which I think may happen), then DY could become a preferred way to benefit from the rising spending and could garner a premium growth multiple (implying all time highs). The street is underestimating DY’s EPS and free cash flow generation and the upside from resurgent spending from their largest customer (AT&T) and over time (likely ‘14-‘15) cable customers who have lagged the telcos in upgrading their physical plant.  Rising housing starts, digital rollouts, wireless backhaul, small cell roll outs (see cuyler1903’s great writeup on STRP) and a federal telco rural stimulus bill coming in ‘14 will all support growth.  However, the driving force is the consumer’s need for ever faster internet speeds and the exponential increase in wireless data usage and competition between cables, telcos, satellite and new entrants (Google Fiber). 

Telecom/cable is mostly about the infrastructure and DY helps companies upgrade and maintain theirs.  It allows custo15.5mers to essentially use a non-union outsourced workforce that it can flex up and down depending on demand without having to pay benefits. Consequently, what DY does is very important to its customers and often when they need a job done it is: 1) mission critical in an area (e.g. post storm work to get their systems back up); or 2) central to the customers plan to expand and keep/take share (e.g. Verizon FIOS plan or AT&T’s U-verse expansion or their wireless upgrade projects).  In either case, price isn’t the mitigating factor, it’s service and work quality.  That is not to say that it isn’t competitive, because it is (as evidenced by the sub 20% gross margin the last 8 years).  However, many of DY’s Master Service Agreements (recurring revenue) have been in place for years in many regions and haven’t gone out for rebid in a while due to their high service quality and customer attention.  77% of DY's revenues come from MSA work and/or LT contracts which are fairly recurring in nature. 

Valuation

 DY's FY ends in July and gets reported next week; below are my fiscal and calendar year estimates.  The street is about 18% below my estimates for the next couple of years; they were even lower but after DY beat and raised guidance the last two quarters, they raised their estimates.  Importantly, you can see that my out year estimates assume very little growth but solidFCF.  I suspect that DY will surprise on the upside as their customers continue to spend but I prefer not to bank on it for my valuation.

Downside is low since valuation is only 7.1x trailing TTM EBITDA and 6.0x FTM EBITDA and a 12% FCFyield. EPS is being masked by $0.43 p/s of non-cash (amortization) charges that the street is ignoring it seems but will start to decline soon in FY 2014/2015.  I can see it trading to $45-50 per share which would be 7.5x-8.3x FY15E (July) EBITDA and downside is $20 p/s (4:1 upside vs., downside) or 5x FY14E EBITDA if I am too high on my estimates and growth doesn’t materialize as quickly as I suspect.  If things get hot in the sector, and management hits the EBITDA %'s it laid out a while ago (13-14%), it could trade to 10x EBITDA on better numbers than I have modeled or about $68-73 per share.  For comparison, Mastec and Quanta both traded at this level in the past year as their primary end markets (pipeline & electric transmission) heated up and investors looked for a way to play the trend. 

F4Q13E - DY will report their earnings next week.  This is not a call on the immediate earnings as I think this story will play out for the next 2 years. However, I do expect them to beat their guidance which is $455-475 mm in revenue and $0.41-0.47 p/s in EPS.  FYI, this is the first time they have given specific EPS guidance in years.  My expectations are for revs. of $484 mm, EBITDA of $61 mm and EPS of $0.51 p/s ($0.67 p/s on a cash basis).  Guidance for F1Q14 should be better than consensus as well.  

 Key Investment Points:

What is the variant perception?  The detailed answer is in the bullets below but to summarize, DY repurchased nearly 1/3 of its outstanding float the last 8 yrs and subsequently it acquired its largest competitor in an all cash deal in Dec. '12 and is now clearly the largest telecom/cable contractor in the country by a factor of 2x.  Scale will bring benefits.  There are numerous charges running through its P&L that are obfuscating its true earnings power and the street isn't paying attention and that creates an opportunity as we enter the next FY.  Plus, after years of tight spending, its customers are all increasing capex to remain competitive (a trend I believe will accelerate – I can add customer comments in Q&A) and DY is positioned to benefit disproportionately as it has the only true national footprint and the most experience and industry relationships.  The street hasn’t come around to the idea yet that telco/cable capex is going to continue to rise.  A low relative and absolute valuation and exploding free cash flow (which few sell-siders model or focus on) will drive the story while the street races to catch up to the potential growth.  The business and the FCF is much less volatile than the stock price as there is no dedicated shareholder base that invests in this sector.  Consequently it has attracted renters not owners.  Consistency may improve that the next couple years.  As with many good investment ideas, this information is hiding in plain sight. 

• Low valuation despite records and positioned to get much better – DY will report record revenues and EBITDA in FY13E, yet trades where it did 5 and 10 years ago and below where it did 13+ years ago.  Valuation has compressed from double digit EBITDA multiples to low/mid single digits. Few analysts follow it and cover it well as they “lost their comps” as Mastec (NYSE: MTZ) diversified, Quanta (NYSE: PWR) divested its business to DY and others were acquired.  Meanwhile, DY stuck to its knitting, generated FCF, bought back stock and is the last man standing in its sector and positioned to reap the benefits as growth returns.  It should be able to return to 12-14% adjusted EBITDA margins in the next 2 years, levels last seen in the '04-'07 timeframe (up from 8.7% in FY10, 10.5% in FY11, 11.2% in FY12, and 11.4% in FY13E [held back by lower margin PWR biz]).  My estimates only assume they will get to 12.7% in F2016 so if they manage to exceed that the stock should go much higher.  The street doesn’t see any of this yet as they are using much lower #'s.
• Stock repurchase should benefit equity holders – DY has repurchased 32% of the company in the last 8 years (15% the last 4 years), and still has an authorization outstanding for another 3% of the company ($22.8 mm).  In total, DY has spent $311.5 mm to buy back 18.417 mm shares for an average purchase price of $16.91 per share (35% below current prices).  They have bought stock as high as $22 and as low as $7.  It has its lowest share count in 15 years which will result in outsized gains for equity holders as growth accelerates.  Although this seems obvious, it hasn't been fully appreciated by the street as most of the stock was repurchased during the recession and the addition of Quanta's telecom subsidiary in F2Q13 has impacted GAAP earnings with a host of charges and costs that the street isn't backing out.  Outside of establishing a dividend (which it doesn't have), DY has been very shareholder friendly with its cash flow.  In my opinion, management thinks like owners as insiders own 5.5% of the company.
• Under-followed by the street with no “bulge bracket” coverage – DY is covered by 7 sell-side firms.  I know that sounds like a lot of analysts writing on it for a small-cap stock, but the analysts are all small regional brokers (e.g.FBR, BB&T, Raymond James, DA Davidson, Stifel, etc.) with minimal clout on the street.  And since DY has rarely needed the street for financings (they haven't done an equity deal this decade), and its trading volume has shrunk as it bought back so much of its float, the street treats this like a distant relative - i.e. see it/write about it 4 times a year and then forget about it.  In fact, after speaking with an analyst recently, it was clear that their marketing packet had the wrong #'s for DY and they weren't up to speed on the story.  When I asked how often someone asks them about DY, the response was "never".  I bought more after that.  To see how few people know DY, going to the Yahoo message boards on it yields 1 message in the last 6 months from wavesearcher99 who seemed to be wondering where everyone is as his message reads "Tommy can you hear me?".  Indeed.
• Acquisition leads to upside and modeling confusion for street – DY completed its largest acquisition in its history, for cash, in December '12, when it bought its largest competitor in PWR’s telco division, which had been under managed and non-core.  They are integrating it this year as the revenues are coming in better than expected too (likely closer to $485 mm in calendar 2013 vs. $400-450 mm forecast).  This deal resulted in non-cash deal amortization which is meaningful relative to reported EPS (35% of total).  Street estimates are using the lower # and analysts rarely reference the cash EPS.  This deal helped set up DY’s capital structure nicely as they tacked on bonds to their outstanding high yield debt (7.125% rate) and used a LIBOR+ 200 term loan and their revolver for the rest.  Out of $440 mm in gross debt, $281 mm of it is HY debt that isn’t due till 2021 and covenants are very loose.  DY's blended cost of debt is close to 5%. DY’s leverage ratio is less than 2x net debt/Calendar 2013E EBITDA, although the street doesn’t yet realize it. Covenants allow for 3.0-3.5x. I think DY only pays down the small portion of its debt that is on its revolver and looks for more acquisitions (not expected by the street).  The street thinks they will pay down debt but truthfully hasn't really thought about it much.
• DY is expensing ongoing costs for the PWR deal in their FY13 P&L without the street (or me) taking them out of the #’s – Management mentioned $2.3 mm in pretax integration costs ($0.045 p/s) on their cc so far in FY13 year and expects another $1.4 mm ($0.025 p/s) in the F4Q13.  Overall that’s about $3.7 mm pretax ($0.07 p/s) in FY13E costs that should not repeat in FY14. 
• Growth returning and accelerating (wireless) - FY11 revs grew 4.8%, FY12 16% and FY13E will grow 34%. Some acquisition related in 2013 of course but still nice growth. Adjusted (stock comp) EBITDA growing faster at 26.9%, 23.9% and 35.8% respectively. Organic growth is accelerating too from low single digits to high single/low double digits the next few quarters. This is being driven by the insatiable demand for bandwidth and computer speeds and new entrants pushing incumbents to upgrade.  I didn’t delve into customer spending and all the accelerated capex plans that are on the table, but suffice it to say that commentary on all their customer’s conference calls and in their presentations indicate that capex is going up.  Wireless spending is benefitting DY as well as their wireless business has exploded from a annual run rate of $70 mm in October 2012 to $200+ mm last quarter.  Also the low cost of capital is helping its customers as they are pretty much all investment grade or close to it.
• FCF will explode the next 3 years as DSOs decline - Growth and customer resurgence should drive strong FCF generation.  FCF should be pretty solid the next 3 years as it works down PWR’s high DSOs (PWR never focused on cash collection [as they were incentivized by revenue] and have govt. stimulus work burning off at higher than normal DSOs) and have a large differential between D&A and net capex.  Since most of DY's net working capital is DSOs, focusing on this will make a big difference.  Each day of DSO improvement is $4.9 mm in FCF improvement.  DY's current DSOs (post the PWR deal) are running about 11 days higher than their historical average (83.5 days now vs. 71 day avg DSO pre PWR deal) implying about $55 mm ($1.62 p/s) in excess WC that can be generated in the next 2 years.  I assume they only get $25 mm of that in FY14 to be conservative.  I think DY generates $3.00+ p/s in FCF in FY (July) '14 and about $8.00+ p/s cumulatively in the next 3 FY’s combined. That’s 31% of its mkt cap in 3 years and a 12% FCF yield for '14. The street is using low #’s and giving them no credit for the massive cash generation coming as almost no one models cash flow or DSOs.  This wont stay here if I am even close to right. 

• Stealth housing play – 9% of its business ($128 mm) is directly related to housing and construction. It used to be 17% ($200+ mm) but the business declined as housing starts and non-res construction faded. They are the largest “utility locating business” in the country. Anytime you want to even move a mailbox, you need to call them to see if you will hit a gas line, etc. They are seeing this business pick up now. It has lower DSOs (45-50 days) than their typical business and is at multi-year low margins. This could be a nice tailwind in the next few years. On DY’s cc on 5/22/13, its CEO said: “And I think underlying all of this is a continued sense from all of our business units with exposure to housing that while it is not a robust contributor today, every day that goes by it is getting better. We surveyed all of our business units as we updated this forecast, and almost without exception, across the country, people were seeing upticks in housing activity. It's not clearing 200 acres and starting a brand-new subdivision, it is completing phases that were suspended in ‘08 and '09. It is initiating additional phases of existing subdivisions. But it's consistent with a theme that I think we will see all year, which is existing improved lots are going to be absorbed, and at that point, the new infrastructure has got to be built. So I think generally we feel very good about the spur to housing, which has always been a good driver to our business.” No one on the street is really talking about this either.

• This is not like a bulge bracket E&C which tends to blow up – Despite many on the street comping this to the overall engineering/construction space, there isn't much comparison.  There is minimal % of completion accounting as DY's work is fixed unit costs and there is no large capital needs (a la fixed price contracts). Also, margins are much higher than general E&C but of course the market size is smaller too.  Plus they generateFCF consistently.  Finally, you can sleep at night knowing that DY wont report a surprise $100 mm cost overrun to complete projects like McDermott (NYSE:MDR) just did andFLR often does as well.  This should result in a higher valuation.
• Exposed to a historically slow growth, cyclical sector but maybe it can get hot – I hear the argument a lot that wireline is “going away”.  While I believe that it isn't true, it’s partly why EBITDA multiples have declined meaningfully for DY from 11-14x EBITDA in ‘99/’00 to 4.5x-7.5x the last 5 years as capex shifted to maintenance mode for some customers. Then came consolidation and large spends by VZ (FIOS) and T (U-verse) and other spends. But as you see from PWR & MTZ, if guys get excited about an end mkt (pipelines/power), they can take the stocks up to high heights and high multiples (10x+ EBITDA). I think telco/cable might get exciting the next 2 years as bandwidth explodes and overbuilders (GOOG fiber, rural telcos) come back. Either way, its potential upside and a free call option and certainly NOT in the share price here.

• 2 potential IPOs could make the street pay attention in late '13/’14 and '14 -  Catalysts are always needed for the street to pay attention to a sector, and 2 potential IPOs might be that catalyst.  Commscope, the largest coaxial cable maker in the world as well as the largest wireless equipment/systems provider, has filed to go public.  Taken private by Carlyle group a few years ago, this story may get people excited about telco & cable spending (http://www.commscope.com/company/eng/index.html).  As well, Goodman Networks (http://www.goodmannetworks.com/) is a private company (with public HY debt and financials (see their latest S-3) that is acquiring Multiband (NASDAQ: MBND) and might be positioning for an IPO in 2014. Pro forma the Multiband deal, Goodman may have close to $1 bb in sales (although they are much less profitable than DY with so much more customer concentration).  In fact, DY has been taking share from them in wireless backhaul for AT&T.  Nevertheless, a deal might get the street to pay attention to the comps and they will find DY looking pretty attractive and growing nicely.

Risks

1. High customer concentration – DY works for a highly concentrated group of customers that have leeway in their ability to adjust the timing of quarterly (and sometimes annual) capex plans.  This leeway could cause DY to miss quarterly estimates.  Its top 5 customers usually represent 60-64% of sales.  This has been the case for more than a decade and DY handles these relationships well.  On a TTM basis, its top 5 customer concentration is the lowest it has been this century at 55%.  Also, DY typically had a 20%+ customer each year (whoever was upgrading their infrastructure aggressively), but now has no customer larger than 14.5%, implying more balanced growth.   
2. 100% tied to North America – While I view this as a positive in the current environment, the company lacks any geographic global diversification; it doesn’t have plans to expand internationally, except for maybe some small expansion inCanada.  If theUS sinks into recession and housing stalls, DY would be impacted.
3. Seasonal business so weather risk is high – DY’s fiscal year ends in July, so its strongest quarters are those tied to Spring/Summer (F1Q and F4Q) and its weakest quarter is Winter (F2Q).  F2Q is always subject to weather considerations/storms and typically represents around 22-23% of annual sales.  Sometimes the street gets this number wrong which creates opportunity.  Conversely, their bestFCF generation quarters are their weakest (F2Q & F1Q) since they generate working capital.  I think F2Q14E estimates are currently low enough so as not to pose a risk.  
4. Acquisition integration risk – In any acquisition there is the risk of overpaying and flubbing the integration.  DY has done 11 deals the last 10 years and 31 since ‘97.  While most of these were small (<$60 mm in revs.), it’s always on the lookout for accretive, geographically strategic acquisitions that strengthen existing, or add new, relationships.  DY is not particularly acquisitive relative to some of its peers and most of its growth has been internally generated the last 5 years.  Mitigating these risks is their stinginess with stock (their last 10 deals were all cash), their experience in integration and top management continuity.  Its most recent acquisition of PWR’s telecom sub was the largest in its history (paid $315 mm [$275 mm + adjustment for excess WC of $40 mm] or 0.55-0.60x FTM revs.).  In my experience, if a deal has skeletons in the closet, it’s apparent in the first 9 months post deal.  So far so good but the jury is still out.
5. Succession plan – I don’t think one exists.  Management is fairly young, but I don’t think the bench is deep. Steve Nielsen (50 yrs old) has been CEO since March ‘99 (andCOO from ’96-‘99) and runs the company.  Tim Estes (59) has beenCOO since September ‘01 and prior to that ran one of their main subsidiaries for years.  Andrew Deferrari (44) has been CFO for 5+ years and been with DY for 9 years.  In the tragic event their plane went down, the plan would be to promote from within, hire from outside or sell the company.
6. New technology supplanting legacy telecom/cable infrastructure – DY does work for legacy telcos & cables and most of its sales are tied to legacy wireline and cable networks.  Competition and new technology is what drives capital spending. I always hear this as a risk when talking about DY but truthfully perception is greater than reality.  

Catalyst