Description

Integrated Electrical Services has been written up twice before on VIC. The performance of IESC post each write up has been quite good (since the first write up in 2016, free cash flow has tripled). My write up focuses on the current and what I believe to be temporary situation the company finds itself in today and the current risk-reward of the investment, so if you want more detailed background on company history / management I would encourage you to look at the previous write ups. 

The thesis for IESC today is fairly simple: 

1. The company has very low capital intensity and low leverage
2. It is positioned well in growing markets (although, at today’s valuation, you will make plenty of $ even if there is no growth whatsoever)
3. It is run by a good capital allocator (EBITDA in non-housing related segments has grown from $11 million in 2013 to $67 million in 2021)
4. The company is cycling through a number of short term issues that is causing an exceptionally depressed stock price (thanks to low public float)
5. Management has significant skin in the game, and insiders recently started purchasing shares alongside company buybacks (the company purchased roughly 1% of shares outstanding from 6/30-8/2, a significant ramp up from the previous quarter)
6. The company does not hold conference calls and is not followed by analysts, adding to obscurity and stock pressure

The market is currently offering an opportunity to buy this enterprise at roughly 6-9x normalized after tax cash flow at 25% tax rates (depending on conservativeness of assumptions, despite the company still having some NOLs, and assuming no value for the company’s “non-core” C&I segment) and 5-6x EV/EBITDA which is a substantial discount relative to previous and successful write ups as well as competitors who typically trade at roughly 8-10x EBITDA. While some may consider this a “jockey stock”, performance from the current stock price depends much less on the capital allocation skills of Jeff Gendell and much more simply on the normalization of current operations, so “key man” risk is actually quite low at today’s valuation. 

Overall, I estimate there is the potential to earn 20-30% IRRs on this investment (worth $52-63 per share today and $70+ per share three years from now assuming no growth in the business), and most importantly with very little downside risk: in the bear case, I see essentially no downside. 

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As a brief overview, the company has three key operating businesses: 

1.       Communications:

This segment provides electrical installation services (think designing the electrical infrastructure of buildings and the maintenance of that infrastructure) for two primary markets: data centers and distribution centers. This business has seen significant growth over time with an organic revenue CAGR of 15% from 2012-2019 and 18% from 2019-2021. Despite the recent slowdown in distribution center spending, the segment reached record revenue in the quarter ended 6/30/2022 (11% sequential growth) and backlogs continue to increase (11% sequentially) as data center spending remains strong. This suggests the segment skews more toward data center projects relative to distribution center projects, which all else equal is better as data center spending should be relatively less cyclical (it is critical infrastructure) than distribution center spending. Importantly, the key competitive advantage in this business is reputation and skill, not necessarily scale or being a low-cost provider (as far as I can tell, given the critical nature of data centers specifically, reputation / skill are the most important factors in determining providers), which benefits the company greatly given their strong and long operating history. This is highlighted by the fact that “a significant portion of Communications business volume is generated from long-term, repeat customers.” 

2.       Infrastructure solutions

This segment provides motor maintenance and repair services and also provides custom generator enclosure manufacturing solutions primarily to data center (via cross selling to customers in the Communications segment) and utility customers. Over time, the growth profile of this segment should begin to more closely align with data center spending and growth in the Communications segment as 40-50% of revenue is derived from the generator enclosure business. In a recessionary scenario, the business should also prove relatively stable given its repair/maintenance services and end markets of utilities and data centers. 

3.       Residential

This segment provides HVAC and other installation services to multi and single family homes, and its key driver is housing starts. Roughly 2/3 of the business comes from single family, and the company is positioned in the best markets (FL, TX, GA, AZ, and NC). The segment has also been taking significant market share in its key markets: housing permits (rough proxy for starts) in TX, GA, AZ, and NC increased by ~70% from 2014-2021, while residential segment revenue grew 170% largely organically (backing out Florida acquisitions and some small others). The business continues to grow despite the recent slowdown in housing (revenue grew from 3/31-6/30, and backlogs are up sequentially).  

The company also has a fourth segment (Commercial & Industrial) which is essentially irrelevant for the purposes of the investment; operating income contribution has been erratic, and should the segment be a drag on cash flow, I would expect management would close or sell the business. While I have not underwritten this outcome, it would undoubtedly add to the upside as consolidated metrics would improve (ROA, ROIC, etc.) and/or the company would at least get some cash for selling the segment. 

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Today’s opportunity exists because the company is currently cycling through a number of short term issues that are causing extremely depressed fundamentals: 

First, the company expanded its Communications segment into a new line of business that proved exceptionally unprofitable. Over the past two quarters, the company took a $17 million hit to gross profit, and it was previously uncertain as to how much of this work was left to be done / in the backlog. In the recent Q, the company mentioned they only have $2 million left in backlog relating to this work (no previous backlog figure was given), after which point the project type will be discontinued. This whole debacle was unexpected and the stock got hit hard. The work should be done soon, and margins will revert. The company recognizes the failure here and is working quickly to resolve it. Mistakes happen, and given the long operating history of the company, I don’t see any reason as to why this performance is indicative of future prospects. 

Second, in November 2020 the company purchased a new generator enclosure business in its Infrastructure Solutions segment. As part of the subsequent growth in the segment, the company engaged in a capital expenditure plan to move the now larger generator enclosure business to a new facility which should ultimately improve margins in the segment. Near term gross margins, though, have taken a significant hit as a result of the move. These things take time, and the company reported that the move was completed in the most recent quarter. Margins in this segment should begin to revert soon. 

Third, the company is getting hit with operating inefficiencies as a result of supply chain related issues, and margins have declined from 2021/pre-pandemic levels (note that this issue is not specific to IESC; most other competitors are also experiencing margin pressures). Similarly, the company is also operating with higher than normal working capital as a result. Margins should normalize from these levels over time, although you don’t need to underwrite that case to make a fair bit of $ at the current valuation.  

Fourth, the Commercial & Industrial business reported significant losses in the Q2 quarter as a result of mis-managed projects. As such, the business segment is on a strict leash and management alluded to the fact that all options are available for the segment. Since Q2, the segment has gotten back to break-even profit and so the issues there seem to have been resolved. Similar to the hiccup in Communications, the losses there were very surprising, although they seem under control now. 

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To value the company, I use a number of different scenarios, although the focus of the below will be on the recessionary case. Also, in both my upside and downside cases, I use a 13x free cash flow multiple which strikes me as conservative for the following reasons: 

• Even assuming a 10 year of 4%, a 7.6% yield is attractive 
• A significant portion of profitability is tied to critical infrastructure (utilities / data centers) which should be relatively less cyclical 
• Other similar companies (EME, PWR, MTZ, MYRG) traded at 8-10x EBITDA pre-covid (13x cash flow would equate to ~9x EBITDA for IESC)
• The company carries low debt and more importantly has a high variable cost structure so overall profitability should be more stable than your run of the mill cyclical business 

In a downside / recessionary case, I assume the following: 

• Operating income in the residential business (revenue tied to housing starts) falls by ~50% from current levels (housing starts fell 66% from 2006/2007 to 2009), and given that the business has low fixed costs, the decline in revenue should be more or less equal to the decline in operating income (similar to what happened from 2007-2010). I view this scenario as very unlikely given the housing shortage, but nonetheless this would imply roughly $36 million in operating income. Note that this case is based on current operating margins of 6%, which compares to operating margins of 7.4% in 2021 and 7.5% in 2020 (although roughly in line with 2018/2019). 

• Operating income in the communications business should stay relatively constant given the secular growth of data center capex (I have yet to see signs that this is going to decline, and generally big tech reported it will be increasing year over year, although at a slower pace), but nonetheless let’s underwrite a ~20% operating income decline from current though more normalized levels (note that from 2007-2010, this business was actually exceptionally stable). This would imply $38 million in operating income. Note that this assumes gross margins of ~16%, which compares to 19% in 2021, 20% in 2020, 18% in 2019, and 18% in 2018. 

• Operating income over time in the infrastructure solutions business should start to more reflect the path of the communications business as the generator enclosure business grows. Given that, let’s assume a 20% decline in operating income from relatively more normalized levels, which would come out to $9 million of operating income. Note that this assumes 7% operating margins, which compares to 14% in 2021, 15% in 2020, and 10-11% from 2017-2019.   

• The company has corporate expenses running ~$16 million per year. 

Together, all of this comes out to a downside after tax cash flow figure of ~$52 million. At 13x that, which would probably be a cheap multiple on downside earnings, the enterprise value comes out to $676 million compared to an EV today of ~$800 million. Note that the EV in a downside case would be considerably less than the $800 million today because there would be substantial working capital release in the event revenues fall, and cash will be generated from the current projects in the backlog. Also, the company is carrying excess working capital as a result of supply chain issues, which in the event of a recession would also probably convert to cash. Nonetheless, if you determine that cash generated by the business for the remainder of the year will be a conservative $30 million and that excess working capital today is ~$30 million, then there’s probably <10% downside, even when assuming structurally lower margins than the business has had in the past and assuming no working capital release in the event of what would be significant revenue declines. 

As for the upside, I get the following in various scenarios: 

• At the current annualized run rate, assuming the same margins as in the above cases, consolidated after tax cash flow comes out to ~$90 million.
• If you normalize margins in the communications and infra solutions segment a bit, consolidated after tax cash flow comes out to ~$101 million. 
• If you normalize for housing starts (at 2021 levels, which ought to be representative of normal given the housing shortage), and assume more normal margins in comm/infra, cash flow comes out to ~$90 million. 

At 13x those figures, you get valuations that range from $1170-1313 million. Compared to today’s EV of $800 million (which doesn’t back out excess working capital or cash to be generated from the business), upside comes out to a range of 55-76%. If you assume normalized working capital and accounted for cash generation for the next 6 months, then upside would become 64-85%. I like to look at three year returns, so if you add in cash generated over that time at the current run rate upside becomes 104-126% (>26% IRR over three years). 

What should be highlighted here is that none of these valuation methodologies account for growth in the business, which is highly likely to occur (backlogs as of 6/30/2022 grew 11% sequentially, so the normalized operations come next quarter should get an 11% higher valuation than the one I’m assuming right now). You could easily assume some non-zero growth rate over the next few years and there would be considerably more upside to the above cases. 

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In all, an investment in IESC strikes me as particularly asymmetric, especially given some confirmatory evidence in the form of buybacks (the current amount of shares repurchased is the most the company has repurchased over the past decade) and insider purchases (the first time since the depths of Covid this has occurred). Further, the investment does not require any heroic assumptions to achieve satisfactory results; you are largely relying on mean reversion once current projects / investments are lapped, and most importantly there should be very little downside from the current stock price in the event things go poorly. The company’s recent buyback program should also add considerably to the upside, especially if buybacks ramp up in the current quarter as it seems they have. 

DISCLAIMER: The Author currently holds a long investment in the securities of Integrated Electrical Services (Ticker: IESC) and stands to benefit should the price of the security rise. The Author may buy or sell long or short securities of this issuer and makes no representation or undertaking that Author will inform the reader or anyone else prior to or after making such transactions. While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note and disclaims any obligation to update such information. The views expressed in this note are the sole opinion of the Author, which may change at any time. The reader agrees not to invest based on this note and to perform his or her own due diligence and research before taking a position in securities of this issuer. Reader agrees to hold Author harmless and hereby waives any causes of action against Author related to the above note. This written note should not be construed as a recommendation to buy or sell any security or as investment advice.

Catalyst

Continued buybacks

Normalizing margins in Communications as projects roll off

Normalizing margins in Infrastructure Solutions as the facility move is completed