Description
Meadow Valley Corporation (MVCO)
Thesis
The value of the MVCO’s subsidiary, its ready-mix business (RMI), is worth more than MVCO as a whole. Following the upcoming public sale of RMI, you essentially will be getting a debt-free construction services business for free plus some likelihood of a positive litigation settlement which would result in MVCO receiving a cash award amounting to up to 40% of the market cap of the company. My target price on MVCO is $11 per share vs the current price of $5.45 (at the time of the submission to VIC). Under more optimistic assumptions the stock is worth $15 per share.
Background
MVCO is a construction-related company that operates two wholly-owned subsidiaries in two distinct businesses. The company operates a heavy civil construction business called Meadow Valley Contractors, which specializes in the construction of infrastructure projects for public sector customers in Nevada, Utah, and Arizona. Meadow Valley Contractors was formed in 1980. MVCO also operates a ready-mix business, called Ready-Mix Inc. (RMI), which provides ready-mix concrete to contractors in the areas of Las Vegas and Phoenix. This business was founded in 1996 and has been growing rapidly since that time.
MVCO went public in 1995 with a market value of $11.6 mil.
For the 9 months ended September 30, 2004, MVCO generated $124 mil of revenue, $317,000 in operating profit and earned $.01 per share on a fully diluted basis of 3.75 mil shares.
Events
MVCO has filed a Form S-1 registration statement for the IPO of its ready-mix business. The deal is likely to be consummated in about two month’s time. The terms are as follows: 1 mil shares will be sold to the public at a price of $12 per share. MVCO will retain 1.5 mil shares such that 2.5 mil RMX shares will be outstanding following the offering. Given the $12 per share targeted IPO price, the equity value of RMI will be $30 mil.
With roughly 3.75 mil fully diluted shares outstanding, MVCO currently has a market capitalization of about $20 mil. As of September 30, 2004, MVCO had $7 mil of cash on hand and $14 mil of debt outstanding. Upon completion of the offering of shares in MVCO’s ready-mix operations (RMI) to the public, the following will occur: (1) RMI will be a publicly traded entity in which MVCO will retain a 60% interest; (2) RMI will assume an estimated $7 mil of debt from MVCO; (3) RMI will receive proceeds from the sale of 1 mil shares; (4) a portion of the proceeds will be used to repay debt owed to MVCO, purchase plant & equipment, and for working capital. My best guess is that RMI will have $10 mil of debt and about $1.3 mil of cash following its IPO. With 2.5 mil shares outstanding, RMI’s market cap will be $30 million.
As part of the transaction, RMI will repay debt as well as assume debt from MVCO, such that proforma, I estimate that MVCO will have about $2 mil of net cash, no debt, and 60% of RMI valued at $18 mil. Keep in mind, at today’s price, with 3.75 mil shares outstanding, MVCO’s equity value is about $20 mil.
Ready-Mix, Inc.
RMI began operations in Q1 1997. Currently, the company operates 2 ready-mix concrete plants in Phoenix and 2 in Las Vegas, with an additional plant located near Moapa, Nevada. The company operates and leases a sand & gravel crushing/screening plant in Moapa which is 50 miles from Las Vegas. RMI also owns and/or operates 125 ready-mix concrete mixing trucks. RMI produces ready-mix concrete by combining the prescribed type of cement, sand, gravel, and crushed stone with water and usually one or more admixtures (chemicals, minerals, fibers). The ready-mix business is driven by the level of construction activity (residential, commercial and public works infrastructure) in the Phoenix and Las Vegas areas. Competitors in the area include: Rinker, Nevada Ready Mix, Silver State Minerals, Cemex, Vulcan and Hanson. (Information on ready-mix concrete can be found from the national Ready-Mix Concrete Association, the industry’s trade association).
For the 9 months ended September 30, 2004, MVCO’s ready-mix business generated $45 mil in revenue, $3.1 mil in operating profit and $1.8 mil of net income according the S-1 filing. On 2.5 mil shares, that works out to be 72 cents per share for the 1st 3 quarters of 2004.
Valuation of RMX
According to RMI’s S-1 filing, under Risk Factors, the company indicates that its “determination of the public offering price of the common stock is arbitrary”. It was determined by “negotiations between [the company] and HD Brous … and might not be indicative of prices that will prevail in the trading market”. I contend that $12 per share is a fair price and could even turn out to be cheap.
The most closely-related public comparable company is U.S. Concrete (RMIX), the largest independent ready-mix operator in the U.S. Currently, RMIX has a market cap of $170 mil. In 2004, the company generated $500 mil in sales along with $40.4 mil in ebitda, $27.7 mil in operating profit, $34.4 mil in cash flow from operations, $26.4 in free cash flow, and 26 cents per share in earnings. At year end, the company had $201 mil in debt and $40 mil of cash. On its Q4 conference call, RMIX gave 2005 guidance for the following: $530-545 mil in revenue, $47-52 mil in ebitda, and $.36-.43 per share in eps. Based on the numbers provided by RMIX management, U.S. Concrete is trading at 8.2x trailing ebitda and roughly 6.1x 2005 ebitda. On an eps basis, RMIX is trading at 14x forward earnings. My estimate (keep in mind MVCO has not yet reported Q4 results) is that RMX will generate $58-60 mil in revenue in 2004 and $4 mil in operating profit, $5.5 mil in ebitda, and about $1.00 per share in eps. Additionally, it will likely generate between $2 mil and $3 mil in free cash flow during 2004. On those estimates, RMI, when it goes public, will be trading at 7.2x 2004 ebitda and 12x trailing earnings. My best estimate at the moment is that RMI could earn $1.12- $1.15 per share in 2005 (this excludes the company’s current plan to add 60 mixing trucks and 1 portable ready-mix plant in 2005). So on that basis, it would be trading at 11x 2005 earnings.
Fundamentals are strong in the ready-mix business given the high level of residential construction, the steady level of public works construction, and the improving level of commercial construction. This is evidenced by the fact that units (cubic yards of ready-mix) shipped by RMX in the 1st 9 months of 2004 increased 27% vs a year ago and pricing increased 5.9%. My outlook for 2005 is for pricing to continue to rise (with an increase at least as high as experienced in 2004), coupled with good volumes (although not as high as in 2004).
Standalone Meadow Valley Contractors
One of the intriguing aspects about MVCO is that the construction services business (CS) is currently losing money. Business is actually improving with the backlog standing at $103.6 mil as of the end of Q3 2004 compared to $71.7 mil a year ago. In fact, the backlog is at its highest level since 1999. However, due to a single contract job in Utah, the entire company is basically breakeven with the CS segment posting a loss ytd in 2004. The money-losing contract in Utah (Gooseberry Project) has been masking an otherwise profitable and healthy business in Arizona and Nevada. The company recognized a loss of $2.6 mil in Q3 and $3.8 mil loss ytd on the Gooseberry Project. This is a project that involves the paving of a 13 mile stretch of road in Utah that was supposed to be completed years ago. Due to cost overruns, an aggressive bid by MVCO, and unanticipated project changes by the state of Utah, MVCO has had to bear the burden of the losses. The company will likely litigate for a refund but for now the company is required to honor its contract and complete the work. The company has stated, although it is difficult to tell from an outsider’s perspective, that it has reserved for any future losses which are expected into 2005. The job is due to be completed by June 2005 and the losses from Gooseberry will then go away. In backing out the losses from this project, I estimate that the company, as a whole, earned 36 cents per share, for the 1st 9 months of 2004. The CS segment would have been breakeven on an operating basis, excluding the Utah losses. Additionally, the company incurred some one-time litigation expenses that further depressed earnings. Excluding those as well, the company would have made a little bit of money. Hopefully, following the completion of Gooseberry later this year, I expect the company to begin to show its true earnings power, which will likely surprise people on the upside.
With any construction company that uses percentage of completion accounting, the analysis of financial statements is tricky and only tells you so much. Important things to understand with construction companies, as with insurance companies, are: (1) the quality & competency of management and (2) the process by which they “bid” for business. In order to ensure that MVCO does not duplicate its problems in Utah, two things recently changed at the company. The first is that, going forward, the company has elected to bid on business only in Arizona and Las Vegas (its two original markets). The company has years of experience dealing with the local state & municipal government agencies in these two states and finds that working with officials there to be much easier. The second change that was made by MVCO is that the Board of Directors has modified the way the company goes through the bidding process. Going forward, the CEO of MVCO is required to sign off on every contract that the company decides to bid upon. This will hopefully act as a check against overly aggressive bids and prevent another Gooseberry from occurring.
Over the last few years, due to losses from the Utah project as well as one other prior project, the company has been constrained in its ability to bid for work. This is because construction companies like MVCO are required to put up surety bonds for the work they do. As the 2003 10-K points out, MVCO’s bonding capacity has been limited since 2001 when it was limited to a total program of $75 mil vs $300 mil in 2000. The good news is that the recent improvement in financial performance at MVCO has led to additional increases in it bonding capacity. The net result should be that the company will be able to expand its business and its top-line (through its ability to bid on a greater universe of contract jobs). If you believe (as I do) that the public works construction market looks to remain strong and/or improve from current levels (as state budget deficits begin to disappear and state governments open their wallets), this increase in bonding capacity at MVCO will allow for a recovery in the top-line and help drive better earnings at the company. The increasing backlog at MVCO is partial evidence for this already occurring.
Valuation of the CS Segment
What can the construction services business earn in a normalized environment? And what is the appropriate value? Assuming the company gets half-way back to its peak level in sales in its construction services segment to about $145 mil (versus in 1999 when it achieved $195 mil in sales) from where it is now and assuming a 1.5% net income margin, then it is not unreasonable to expect the stand alone construction company to earn about $.55 per share. Keep in mind when you look across the construction industry at comparables (FLR, GVA, SGR, JEC), the average 10 year net income margin ranges between 1.7% to 3.3%. You can assign the P/E multiple that you think is appropriate but currently similar construction services companies trade at between 13x and 21x 2005 earnings. On an EV/sales basis, other construction companies trade at about .4x EV/sales. Using that metric, the CS segment within MVCO is worth $11/ share based on 2004 sales of $103 mil.
One final, interesting point to note with MVCO is that they are likely to win litigation settlements from past jobs. It looks like that amount could reach $5-8 mil. So, on top of the $2 mil in net cash that the company will have proforma for the IPO of RMI, I expect the company to potentially bring in another $5 mil or so.
Litigation Issues
As the latest 10-Q points out, “claims for additional contract revenue are recognized only to the extent that contract costs relating to the claims have been incurred and evidence provides a legal basis for the claim.” Currently, the company has $10.5 mil claims outstanding and has recorded $3.5 mil in claims receivable. Two contracts with the state of New Mexico are being litigated. The total claims on these two contracts amount to $8.33 mil. The issues that the company is charging are that there were plan errors & omissions and contract modifications with the projects. The status is pending. Additionally, the company won an arbitration case with Clark County, Nevada over a contract dispute worth $2.1 mil. Since Clark County can appeal the decision, MVCO has not reported the claim on its balance sheet. However, I consider the odds of success in receiving this amount or slightly less to be high.
Putting the Pieces Together
So what is MVCO worth today? I look at this situation such that I am getting an improving construction services business with no debt and some amount of cash on the books (my base case is $4 mil, assuming the $2.1 mil arbitration award is not appealed) for free following the IPO of the RMI business. That is my margin of safety.
Separating out the components, I calculate that RMI is worth $16 per share as a public company. This implies a market cap of $40 mil, of which, MVCO will own 60%. How do I arrive at $16? I am using my 2005 eps estimate of $1.15 and applying a 14x multiple to it. 60% of $40 mil is $24 mil. MVCO’s equity is currently valued at $20 mil. Assuming a recovery in earnings in construction services in 2006 (first full year without Gooseberry), I think the CS segment could earn $.35 per share for MVCO. Applying a 12x multiple (low end of comparables), I get $4.20 per share or $15.75 mil for the equity. Add to that $4 mil of net cash, and the 60% of RMI and you get $15.75 mil + $4 mil + $24 mil = $44 mil. Assuming 3.75 mil shares, that equates to $11.66 per share.
What if things go right for MVCO? Well, the RMI business could do even better than I am assuming. The litigation awards could be 3x what I am assuming. The CS segment could see much better revenue and earnings recovery than I expect. People value the CS segment in-line with the comparables. Under that scenario, the stock is a triple.
Negatives
The following are negatives to be considered when looking at MVCO:
The company is rather aggressive on its granting of options to employees. The last grant amounted to 369,000 shares which is quite high in my opinion.
There is a significant amount of customer concentration at MVCO.
Both businesses within MVCO are dependent on the level of construction in the southwestern U.S.
The company is subject to cost-overruns and incorrect bids in its construction services business. Since the company’s contracts are fixed-price, it is liable for any losses incurred.
Catalyst
IPO of MVCO's ready-mix business