Description

Thesis: This is a simple business that has hit an inflection point while at an unsustainably cheap price. NWPX is a specialized West Coast pipeline builder for municipal drinking water with a record backlog of over $275 million with strong bidding on the 24 month+ horizon. The business is emerging from a four year industry-specific downturn with EBIT margins rising from negative to 10% last quarter and 13-14% in 2020-21. This will continue as revenue ramps and the business should be able to earn over $3 per share of free cash flow starting next year. The $23 stock is even cheaper when you consider that the working capital is $13 per share. We believe the opportunity exists because NWPX is a less liquid small cap with virtually no analyst coverage and minimal investor interest.

Investment Summary: 

In the theme of looking for businesses not subject to normal economic cyclicality, we came across Northwest Pipe, whose end market is driven by infrastructure spending by states on their water distribution. This is a space that has been underinvested in for years, but is now picking back up, which is explained in greater depth below. With the industry beaten up, Northwest Pipe had a backlog below $90 million entering 2018. Last fall, NWPX was able to acquire Ameron Water, its largest West Coast competitor, for around 0.5x Book Value from NOV. This brings major benefits not only to cost synergies but also to gross margins, as they eliminated their largest competitor. The deal came at the same time as industry volume up for bid more than doubled. So now, NWPX enjoys a 50% market share with basically no competition on the West Coast and Central U.S. at a time when locked-in industry bidding volumes are robust for the next few years, gross margins are ramping back toward a 20%+ range, and there is no debt on the books. The business is very cheap, trading at 8x future $3.25/share earnings (or 4x if you count all the working capital), and at tangible book value. This is one of our highest conviction names and we are only limited by liquidity.

Company Background

Northwest Pipe is and always has been a simple business. Although the company has not been written up on VIC since 2001, that report provides a good overview of their core water pipeline business. It is worth noting that the story has not changed, as the US has consistently underinvested in drinking water infrastructure The stock also went on to appreciate over 60% in the year after that writeup as the S&P fell over -25% and return over 300% over the next 7 years into 2009 vs. a flat market. An important caveat here is that in 2005, the company diversified away from water for a time and became involved in other end markets, e.g. oil & gas. That business was divested in 2015, not long after the current management team came on board. In its current form, the company is a water pure-play, and we believe the management team has every intention of keeping it this way.

NWPX makes large diameter welded steel pipes that are used most often in bringing water from its source location or ‘first mile’ end of the spectrum. These pipes have a diameter of at least 5 feet and can be 20 feet in some instances. While this may seem like a simple enough commoditized offering, it is an industry with few competitors of any size and it does require good execution and long standing relationships with utilities and contractors working for them on larger municipal projects. We see NWPX as a best in-class operator that has not had to take a material write-down on a project or had any damages against them by a client. We have visited their facilities and were impressed with their lean manufacturing process. As not only the sole public company in the space, but also the only national competitor, the business has the scale and diversity among end markets and facilities to make the necessary accommodations for its range of projects. 

With one quick look at their financials, it is clear that Northwest Pipe was crushed from 2014 through 2017 with Water Revenue declining nearly 50% and EBIT margins falling from 11% to -12% at their trough. As explained in greater depth below, this was the result of a perfect storm with some oil & gas pipe players attempting to enter the industry just, as the space was hitting its trough in terms of demand. Most importantly, we believe that Northwest is stronger for it, having divested non-core assets, acquired its largest West Coast rival for 50 cents on the dollar, and trimmed its SG&A from 10% of sales to what less than 7%. While we see the business already entering its next 3+ years upcycle, we believe NWPX is in much better shape to handle the next step down in industry volumes if looking 5 to 10 years out.

Competitive Advantage

The company is now effectively a monopoly on the West Coast.

They have a Project Tracking System (PTS) which has 20 years of history for all major water projects in the US and Canada. The software has a 10 year forecast on new water jobs to be awarded. This is accomplished by having 20 salespeople with relationships calling the subs that get the municipal jobs and reading all legislation in progress re: water infrastructure projects and then entering all this data into the system. They know what’s likely to be coming up for bid and when.

Their in-house designed plant software takes the customer designed specs and and translates it into the most efficient workflow at the plant. The joint cuts are made in the most efficient manner and workflow is prioritized for the various components. Workers are trained into multiple segments of the job and move around the site with the material. Tenure is long (10 years was common) as we asked workers at random walking around one of the plants.

This is a relationship business where they are providing a part of a larger project and reputation is very important. They have never had any liquidated damages and they have strong relationships with the subs they work for.

Industry

It is fairly common knowledge at this point that infrastructure in the United States has been neglected for a long time. Drinking water infrastructure is an especially underinvested space, which is often only dealt with when it becomes an absolute necessity. With that said, there has been an increase in efforts to tend to some of the glaring issues with large spending bills namely coming from California and Texas. While in theory, government entities should be consistently ramping their water supply spend at this point, the industry is subject to its own cycles. So while over the long term, this is a constant need with catch up work to be done and many new repair needs happening every year, there will be ebbs and flows to bidding volume from year to year.

Overall, the industry demand was solid from 2000 to 2013 with normalized volumes of roughly 150 to 175 thousand tons of water pipe in projects to be bid on. Subsequently, volumes declined rapidly in 2014 through 2017 as demand slowed in the municipal markets, falling as low as 100 thousand in total tonnage. This came on the heels of three stellar years on robust bidding with high teens gross margins, which, coupled with the oil market downturn, attracted non-traditional competitors into the space. As oil prices fell drastically it drove O&G pipeline companies to look for other work. These novice new entrants drove bidding for water projects down to the point where NWPX did not participate. This smaller share of a declining pie is what caused the aforementioned revenue drop and crushing of margins as utilization just fell too low. Many of these novice new entrants soon exited with essentially only 2 other large competitors left standing outside of NWPX as it stands now. Last year, there were roughly 220 thousand tons bid and this year and the next couple of years are tracking above the 200 thousand ton mark, above average, but warranted given the preceding years underinvestment and current infrastructure enhancement initiatives.

Thompson Pipe and American Spiralweld are the two other names you will often hear in this business as the major remaining competition. The former focuses on the Central and Southern regions and the latter is primarily on the East Coast. Thompson made a similar, but smaller acquisition taking over Forterra’s operations as the industry was bottoming in 2017. Forterra was one of the irrational outsiders that was unsuccessful in water pipes. Management described Thompson as a rational competitor with conservative bidding. However, they just beat out Northwest Pipe for the Atoka project outside of Oklahoma city with a low ball offer that is now delayed due to conservation land issues and pushed across a five year timeline. Even though their backlog is going up, we think the aggressive bid had to do with fear over NWPX’s continued encroachment in their core markets, like with the high margin Northwest win of Bois d’Arc project in North Texas. 

On the East Coast, American Spiralweld is less disciplined both due to their lack of competition and as a result of being a small subsidiary of Cast Iron. They have traditionally been more aggressive bidders with worse economics. They recently built a new plant in South Carolina and a new mill in Flint, Michigan. This sporadic build approach hurts the scale that they should be getting from their overall size. They are supposed to be building a new plant in Paris, Texas but it’s not clear if that will be finished. Coincidentally, Northwest Pipe’s management team sees the Texas market slowing in 2-3 years when this plant may come online, so it may be shelved. Currently, the East coast market has been softer so American is not seeing the growth in backlog that NWPX and Thompson are enjoying.

There are a number of small competitors in southern California and one medium sized player in Kansas, but these businesses have not been looking to aggressively take share and probably would have a difficult time doing so given the Northwest Pipe’s superior economics. The last of the large new competitors to shut down their operations was Jindal, the O&G company. They bought their plants from an Indian conglomerate that underinvested in the business and were not able to run them economically once demand fell off. They still own the assets and could come back online at some point.

A repeat of 2014-2017 slowdown seems the key risk for this story. However, NWPX now controls about 50% of the market vs 35% before the Ameron acquisition and one major competitor is gone. Second, oil & gas pipe players were burned once in this business and less likely to enter again. While it is inevitable that this hot market will slow again at some point this upcycle may last significantly longer given pent up water infrastructure spend that has 10-20 year timelines.

Ameron Acquisition

Transformational acquisitions are a key event that we look for in order to get excited about an investment prospect and that is exactly what the Ameron deal was for Northwest Pipe. They tried to buy Ameron’s water division in 2015 as the market was turning. The asking price at the time was around $100 million, which came out to a roughly 1.3x sales multiple. After a few years of a deteriorating market, Ameron let their neglected water subsidiary go for $35m or about 0.5x sales. NOV had bought Ameron for its fiberglass business and the water segment was a non core asset which they let go with the first opportunity. NWPX management called the 0.6x book value multiple a no-brainer. 

The deal was immediately accretive and added roughly 15% market share to NWPX’s existing 35% with solidification on the West Coast. Furthermore, Ameron brought over plants that specialize in slightly smaller pipes and a large plant in Mexico that they built at the peak of the last cycle where labor costs are one third of what they are in the stateside plants. Cost synergies are being realized quickly as these are simple businesses, and the smooth integration is significantly helped by the fact that NWPX’s head of operations ran Ameron’s water plants before joining. Finally, this deal brings a huge element of pricing power in as NWPX is basically now a West Coast monopoly. Suffice it to say, we think this was a great deal for Northwest Pipe that happened at the perfect time for them. 

Management 

The other impressive part of this story is the management team, which is very diligent and conservative, and owns 3% of the business. They pride themselves on being best-in-class operators. The CEO, Scott Montross, joined in 2011 and became CEO in 2013. He came on board with over 20 years of experience in the steel business and has been focused on optimizing the corporate structure from divesting the Tubular segment, to the Ameron deal, and now looking at diversification opportunities inside their core water business. 

Robin Gantt has been CFO since 2011 after moving to NWPX the year prior. Most recently she has been dealing with the Ameron integration. She is a conservative CFO that under-promises. They typically do not even adjust one-offs in published materials. She is focused on the cash flow of the business and less so on any non-gaap optics. 

Finally, there is the aforementioned EVP of Water Transmission, Bill Smith, who ran Ameron’s water division for 14 years before moving to NWPX in 2010. As previously stated, we have met this team at their headquarters and speak with them regularly. We continue to be impressed with only positive surprises since being involved with the company.

What Happens Next

Just a few weeks ago, NWPX reported its second quarter results with a large beat, showing accelerated improvement beyond what we had anticipated. The backlog broke $275 million vs. $122 million this time last year, showing 14% quarter over quarter growth. What is more impressive is that revenues grew 10% sequentially so this continued step up in backlog is coming at the same time as revenue accelerates. 

These results were somewhat muddied by an accidental fire at a coating facility in Texas that added $3m in costs as a result of outsourced work. This will hamper the GAAP results in the second half, but this is covered by insurance, and the company should see the reimbursements starting in the fourth quarter of this year. Once this is stripped out, the results show a 16.5% gross margin, which is a 600 basis point sequential increase and a complete turnaround from last year’s -4.3% margin. With nearly $1.50 in free cash flow per share in the first half, we believe the company is well positioned for acceleration in future years.

As previously stated, we believe the bidding environment will remain in the 200 thousand plus tonnage range for the next 2 years. Revenue will continue to increase to $270-$300m in in the next two years and gross margins will continue to ramp to management’s 20% target, which they hit in the previous cycle without the benefits that come along with owning Ameron. Operating expenses are running in the $18m range and probably will increase but keep below $20m, creating mid teen EBIT margins. We think NWPX will hit $3-$3.25 in EPS starting in 2020-2021. 

If the right opportunity comes along management may acquire a water-related business that can leverage its current strengths, such as sewage. They only want to add exposure in pipeline end markets that have a stable and long runway. Furthermore, it is important to reiterate that even at 200 thousand tons per year for 10 years, that would not be enough to accommodate the population growth in certain areas and required replacement to the existing water distribution infrastructure, this is a heavily underinvested space with a large runway just to close the gap to a satisfactory level. The thesis does not hinge on a sudden change in municipalities to prioritize drinking water, but it is important to reiterate that although the business has its own cycle, it is a secular grower.

Valuation

We view Northwest Pipe as one of the best opportunities in this late cycle economy as it has already inflected higher since last year’s earnings trough and is uncorrelated with the overall market. We believe the stock’s cheapness is a function of two things: first, due to how badly this industry was hurt in the most recent downcycle and second, a result of being a small cap with low liquidity and little coverage. Although the business is somewhat tricky to value, it is difficult to find a metric on which it is not very cheap.

One can look at valuation in a couple of ways:

• The company could be making over $3.20 per share for a while if industry volumes just stay in the 200 thousand ton range. At 10x and assuming some of the current net cash is excess you get $37

• 1.3x sales on our 2021 numbers gets you to $38

• You are paying $23 per share for a company that will have a tangible book value of close to $31 in two years and earning 11-12% ROEs on that. At just 1.2x BV you get to $37.

While there are no direct comps for NWPX, there are a number of other water related businesses with similar cyclically adjusted margins (e.g. MWA though not a perfect comp). Even without accounting for the net cash, these businesses trade for 12-17x forward earnings vs. NWPX which is around 8x currently. 

Catalysts

1. Further major project wins announced as bidding ramps for this year in the second half 

2. Clean gross margin in the high teens / low twenties consistently reported

3. Any future M&A deal

4. Increased sell-side coverage (company is looking into increasing exposure) and more investor interest

Risks

• Re-entrance of non-traditional competitors but a low probability event

• Infrastructure spend slowdown if states across the country decide to deviate from current plans and re-allocate the spend toward other project categories. This is unlikely to occur after money has been voted and allocated.

• Increased competition from Thomson in the Texas & Central regions.

Catalyst

Catalysts

1. Further major project wins announced as bidding ramps for this year in the second half 

2. Clean gross margin in the high teens / low twenties consistently reported

3. Any future M&A deal

4. Increased sell-side coverage (company is looking into increasing exposure) and more investor interest