Description

We recommend buying Limbach (LMB; $7.60/$61mm fully diluted market cap) given our conviction that the company’s soon to be announced FY 2019 EBITDA guidance will reflect a healthy turnaround in the underperforming Mid-Atlantic region (~20% of revenue & backlog) which has severely depressed TTM consolidated profitability, and as a result has left LMB's stock for dead valued at ~4.5x our base-case 2019 EBITDA estimate despite larger public peers EME and FIX trading ~8-9x EBITDA. Our base-case price target is $15/share based on 7x multiple on $23mm of 2019 EBITDA.

Although the stock has doubled off its December 2018 lows in the mid-$3’s (where we were very aggressive buyers), we believe the stock has at least ~100% upside over the next few months, back to trading levels prior to the string of Mid-Atlantic project write-downs which caused a violent sell-off in the stock. 

Recent events should provide investors relief, but have not yet been fully reflected in the stock

·        3/18/2019: LMB published an updated investor deck for the Roth Conference with new slides regarding the "Mid-Atlantic Turnaround" (see pp. 13-17). At the conference, the CEO, Charlie Bacon, said “we just had to right size the [Mid-Atlantic] business, and unfortunately, we took a lot of pain through the books and our share price took a hit and it was unfortunate, but I understand how that works, [I] didn’t like it, but we’re back on track”. We believe the worst is already behind them, and that management will communicate in greater detail about the Mid-Atlantic turnaround efforts on the upcoming 4Q’18 earnings call

·        3/28/2019: LMB announced a delayed 10-K filing and 4Q’18 earnings call due to needing additional time to reflect in the 10-K the company’s refinancing of its credit agreement. Within the press release, the company released preliminary FY 2018 results, reporting that FY 2018 EBITDA was in the middle of the previously revised guidance range, which implies there were no more curveballs out of the the Mid-Atlantic region in 4Q’18, and that the debt covenants which required at a minimum $6mm EBITDA in the quarter, were not breached

Brief Business Summary

LMB is the 9th largest mechanical HVAC contractor in the nation. The company has a 100+ year-old history serving general contractors and construction managers who design and construct commercial buildings for public, institutional, and private owners. LMB's primary end-markets include healthcare (~18% of backlog), education (~13% of backlog), and Sports Arenas/Amusement Parks (~11% of backlog).

Business Segments

·        1) Construction: ~80% total revenue; 11-13% “normalized” gross margins: LMB manages large construction and renovation projects primarily for HVAC, plumbing, sheet metal fabrication and installation, specialty piping and electrical services.

2) Services: ~20% total revenue; ~20-25% gross margin: LMB provides facility maintenance or smaller general construction services primarily related to HVAC, plumbing or electrical services.

Backlog

·     Committed and promised backlog totaled $842mm at the end of 3Q’18, equivalent to ~75 months of quarterly run-rate revenue that LMB will convert into revenue through 2021 and 2022, which provides excellent out year visibility. Of the $842mm, $488mm is contractually committed, while the balance of $354mm is promised, but uncommitted. Note: LMB only began providing promised backlog at the beginning of 2018.

·        For the $354mm of currently promised backlog, the company enters into "pre-construction agreements" with customers and engages in engineering activity to arrive at the design and associated pricing of the project. Although management claims that not all promised opportunities will materialize as firm projects to be booked into backlog, based on our conversation with management, promised but uncommitted backlog historically has a greater than 90% success rate of getting contractually committed.

·        LMB’s also provides investors with construction TAM, which sits at $3.4B. This figure represents opportunities being tracked by the company and what they intend to bid on in the forseeable future. Management cites a ~40% historical win-rate on bidding opportunities which would translate into another ~$1.3B of backlog if successful.

·        Backlog as of 12/31/2018 was $505mm in construction (+16% sequentially) and $54mm in services (+5% sequentially).

Why is LMB’s stock depressed?

·        LMB’s management team (led by industry veteran CEO, Charlie Bacon) has lost credibility with both the buy and sell side. CL King recently suspended coverage, while Roth ($7 PT) & DA Davidson ($8 PT) remain unenthused, given three consecutive quarters of project write-downs in the Mid-Atlantic region, resulting in EBITDA of only $2mm through the first three quarters of 2018, compared to guidance of $18 to $20mm of full year 2018 EBITDA offered on the 2Q’18 earnings call.

·        On the company’s third quarter earnings call, full year 2018 EBITDA guidance was cut from $19mm at the midpoint to $9mm, implying $6-$8mm of 4Q’18 EBITDA.  As mentioned, LMB has reported that FY 2018 will be in the middle of the range, implying the achievement of 4Q’18 EBITDA of ~$7mm. Although management has taken serious action on fixing the Mid-Atlantic region, LMB remains “in the penalty box” with the market taking a “show me” stance on the business.

·     ·         Management’s promised M&A roll-up strategy has failed miserably. The company has discussed “rolling up” the HVAC industry dating back to its first public call in 2Q’16. However, LMB managed to only get one $20mm deal signed in September 2018, but due to LMB's own business challenges at the time, the deal was terminated by the target company a quarter later (Dunbar Mechanical)

·       ·       Although leverage looks stretched at 3.9x TTM EBITDA, we believe LMB does not have a balance sheet problem and should generate strong cash flow in 2019 to support the debt burden. Net leverage on normalized EBITDA is much less onerous than it appears, and we expect net leverage to drop to 1.3x factoring in 2019 EBITDA growth and cash collections from change orders

Mid-Atlantic Region

·        · LMB took a $9.6mm gross write-down in 3Q’18 in the Mid-Atlantic region (compared to $4.3mm in 2Q’18, and $4.5mm in 1Q’18). YTD gross project write-downs total $18.4mm. Because of these write-downs, LMB’s consolidated construction gross margins have been crushed. Excluding the impact of project write-downs, normalized construction gross margins would be ~1000 bps higher. According to management, over the last ten years, the Mid-Atlantic region has produced average annual revenue of $60mm and average EBIT margins of ~6%.

· Margins ex: Mid-Atlantic Region

·        LMB’s business ex: Mid-Atlantic is performing very well, with YTD gross margins ex: Mid-Atlantic of ~15%, compared to consolidated reported gross margin of ~10%.

·        Normalized gross margins (adding back the write-downs to reported gross profit) in 3Q’18 were ~13% compared to ~12% the same period last year

What caused the write-downs?

·        Mid-Atlantic write-downs were a result of a temporary human capital/labor problem. According to management, typical headcount in this region is ~200 workers. At the peak in September of 2018, total headcount swelled to 350 workers. However, LMB has already taken strict action on this labor problem. Based on our call with management back in December, we were told that the Mid-Atlantic region was operating with~240 workers and that management expected this number to drop back to more normalized levels of about ~200 starting in January of 2019.

·        The CEO, Charlie Bacon, was blindsided by his own team in late September 2018. See comments on the 2Q'18 and 3Q'18 earnings calls below regarding views expressed in "late September" vs. comments made on the 9/20 earnings call. In our opinion, the only possible explanation for this mix up is that Charlie did not have September's "official report" when making comments about the Mid-Atlantic region on 9/20. This would explain why the company has taken action on reporting results out of the Mid-Atlantic region on a weekly basis instead of a monthly basis.

According to management, as of 9/30/2018, projects in the Mid-Atlantic that contributed to the YTD write-downs were 86% complete.

·        A total of (5) projects in the Mid-Atlantic were included in the $9.6mm 3Q’18 write-down of which: (1) project had achieved full completion in early November, (2) projects were expected to achieve “substantial completion” in December, (3) projects were expected to carry into March and April of 2019

·        Management expects the bulk of the labor-induced problems mentioned above will be complete by 12/31, with only “trimming and commissioning work” for the remaining (2) projects to continue in 2019.

·        Importantly, the (2) projects that will be continuing into 2019 are already in a loss position, and according to GAAP, LMB has taken the full loss on the P&L through the end of 3Q’18. Thus, LMB does not anticipate any further write-downs on those projects as they get completed in 1Q’19 and has factored this into their 4Q’18 guidance.

In response to the underperformance in the Mid-Atlantic, LMB took four critical actions for 2019

·        The regional manager who was responsible for the recent Mid-Atlantic cost over-runs was fired and a new regional manager started on 11/15/2018

·        LMB created a new “co-COO structure” and deployed interim leadership and project management from other business units to the Mid-Atlantic region

·        LMB shortened the Mid-Atlantic reporting cycle to weekly from monthly

·        LMB announced they will only be selling “large HVAC projects” in the Mid-Atlantic region after 6/30/2019

We love the setup at ~$7.50/share heading into 4Q’18 earnings for the following reasons

·        Charlie Bacon, who has a strong reputation in the industry for once running Bovis Lend Lease, has been actively buying stock with a recently announced 10b5-1 share purchase plan, and already owns ~4% of the company.

·        Management has de-risked 4Q’18 for any Mid-Atlantic blow-ups. As part of their conservatism, their 4Q’18 guidance assumed $0 EBIT out of Mid-Atlantic Region. 4Q’18 debt covenant (fixed charge ratio > 1.1x) required a minimum of $6mm Adjusted EBITDA to not breach covenants (4Q’18 guidance is $6mm to $8mm; consensus is $3.5mm). We have since learned that 4Q'18 EBITDA will be in the range of $6mm to $8mm, which we believe should help management begin to build back some credibility.

·        Although the Mid-Atlantic region severely under-earned throughout 2018, the region should be a positive EBITDA contributor in 2019. According to management, the $100mm Mid-Atlantic business got “too big” and management has already acted on shrinking the region's revenue to $60-$70mm for 2019, back to the 10-year average revenue generated for the Mid-Atlantic region of ~$60mm, which at this level of scale operated with a ~6% average EBIT margin over this period.

LMB ended 3Q’18 in the strongest net-over bill position in the company’s recent history

·        As depicted below, 3Q’18 left the company in a very strong net over bill position of $20mm, which means that cash flow should be meaningfully positive in 4Q’18. Sequential CFO growth in 3Q’16 to 4Q’16 was robust as the company’s net over bill position in 3Q’16 of $15mm generated $18mm of CFO in the subsequent quarter. Therefore, we believe 4Q’18 could potentially generate greater than $20mm of CFO (~35% of the company’s market cap), which would significantly de-lever the balance  sheet

We believe 2019 consensus EBITDA of $15mm is very low and an easy hurdle to beat & raise

·        We believe LMB can generate at least $20mm of EBITDA in 2019 (compared to $15mm consensus), and as much as $26mm depending on the speed of the turnaround in the Mid-Atlantic region and realization of construction backlog gross margins above those realized over the trailing 12 months

·        The driver of future EBITDA will be construction backlog gross margin, which management cited to be at the higher end of 10-12% range, which compares to ~9% TTM and 4.5% in 3Q’18

·        Management expects 60% of 4Q’18 construction backlog (provided to us in the delayed 10-K press release) will be booked as revenue in 2019, with the balance coming from new orders and change orders

Valuation & Price Target

·        Our 12-month base-case price target of $15 is based on 7x $23mm of 2019 EBITDA which equates to 100% upside from current trading levels

·        Our 2019 EBITDA estimate of $23mm is derived by the following inputs

o   Construction backlog growth of 2-6% with a 1x book-to-bill at 10-11% gross margin equates to $52mm to $59mm of construction gross profit

o   Service revenue growth of 4-8% at 20% gross margin equates to $16mm of service gross profit

o   Therefore, we expect total gross profit from the two segments to be $67mm to $75mm

o   We model SG&A as percentage of revenue of 9.3%. As depicted below, management has done a great job of leveraging SG&A with revenue growth over the past few quarters.

o   D&A of $5mm

o   Stock-Based Compensation of $3mm

o   Equates to $20mm to $26mm of EBITDA

·        Applying a conservative multiple range of 6.5x to 7.5x to our 2019 EBITDA estimate implies an EV of $130mm to $193mm, and an equity value per share of $12 (+50%) to $20 (160%). LMB is trading at a discount to larger E&C peers, Emcor Group (EME; $4.2B market cap) trading at 8.1x 2019 EBITDA, and Comfort Systems (FIX; $2B market cap) trading at 9.2x 2019 EBITDA

Risks

·        Mid-Atlantic write-downs persist into 2019 thus rendering the region permanently impaired

·        Percentage of completion accounting leading to lags between cash flow and profits and write-downs if management has underestimated project costs

·        Funding of multi-employer pension plans

Catalyst

• 2019 EBITDA guidance reflecting healthy turnaround in the Mid-Atlantic region
• Generatng >$20mm of 4Q'18 cash from operations (equating to ~35% of today's market cap)
• Tuck-in acquisitions of 4-5x EBITDA and benefitting from private/public market arbitrage by getting a 6-8x EBITDA multiple