Description

Quanta Services is a company that has been posted to VIC a few times in the past, so I will keep the company description light in this post and focus most of the attention on why the investment is attractive today.

Business Description

Quanta is a specialty contractor with operations primarily in the U.S., Canada, and Australia that operates in two segments.

1.      Electric Power Infrastructure Services ($7.1bn revenue, $0.6bn operating profit in 2019): Through this segment, Quanta maintains, repairs, and upgrades the transmission and distribution (T&D) infrastructure system on behalf of its utility clients in North America. It is the largest such service provider to this end market and benefits from its unmatched scale and solution scope. The segment also includes the telecommunications division, a market Quanta recently re-entered and represents approximately 7% of segment sales. This is an attractive end-market because of the structural growth from the buildout of 5G networks.

2.       Pipeline and Industrial Infrastructure Services ($5.0bn revenue, $0.3bn operating profit in 2019): This segment provides comprehensive infrastructure solutions to customers involved in the development, transportation, distribution, storage and processing of natural gas, oil and other products. Large pipeline projects have been reduced to about 10% of segment revenue and most of the business faces natural gas utilities and midstream customers whose spending has been relatively consistent in non COVID-19 times.

Investment Thesis

·         T&D business underpinned by strong secular growth drivers: After decades of under-investing in their grids, electric utilities are starting to materially increase their spending to 1) “harden” their grids to reduce the chances of wildfires and protect against weather incidents such as wind storms, ice storms, and floods; 2) increase system reliability 3) enlarge their grids to areas where renewable energy will produce electricity (such as solar installations); and 4) prepare for the large changes that will be required by the expected growth of battery powered vehicles. Many of Quanta’s utility customers have publicly announced multi-year spending projections significantly above historical levels. 60-65% of Quanta’s current revenue comes from regulated utility clients.

         Unmatched scale and scope should allow Quanta to grow above industry rates: With $7.6 billion in expected 2020 revenue in the electric power segment, Quanta is the largest player in the industry. Quanta arrived at this position by self-performing more than 85% of its work which has allowed it to provide additional price certainty to clients. The company has also spent more on training and workforce development than other companies in the space. We expect these strategic decisions to allow the company to grow at above market rates as they have in the past.

·        High quality of earnings relative to contractor universe: In 2020, Quanta expects about 90% of its revenue to come from base business activities. These activities consist of recurring small maintenance jobs as opposed to large projects which tend to vary more year-to-year.

·        Strong balance sheet and management has historically been a good allocator of capital: Quanta is currently levered at approximately 1.4x based on an EBITDA figure that is significantly below normalized in 2020. This gives the firm the ability to deploy capital in shareholder friendly ways. Historically, Duke Austin, the CEO, has used his balance sheet to opportunistically repurchase shares and to do small acquisitions of maintenance / utility facing assets. We believe this is a good use of capital for this business and expect it to continue. One of the long-term compensation metrics the board has recently put in place for management is a measure of ROIC improvement.

Reason for Mispricing and Valuation

In the wake of the COVID-19 situation in the United States and the collapse of OPEC+ talks, Quanta has had to take down its 2020 guidance materially: about $180 million or 17% on the EBITDA line. The majority of this guidance revision is in the Pipeline and Industrial Infrastructure Services segment where the company has been more effected. For example, while the business operations were deemed essential, Quanta was not able to perform much of its gas distribution work due to stricter stay-in-place orders in many cities. Stronghold, an industrial services business acquired in 2017, has seen significant declines in activity. With refinery throughput down materially, the catalysts handling services they perform will be down. Furthermore, turnaround activity is being reduced as refineries are reluctant to allow crews onsite to protect the safety of their workers during COVID. The midstream pipeline and industrial business has also seen a significant pullback. In the Electric Power Infrastructure Services segment, Quanta is in the process of exiting a failed attempt to grow the business in the Peruvian market. Quanta expects to lose about $25-30 million in EBIT in the Latin American market this year. Following a tough year in 2020, we expect the majority of this business to come back and, coupled with the industry tailwinds, lead to enhanced growth and a rerating of the stock creating significant value for shareholders.

Using the midpoint of guidance for 2020, management expects revenue of $11,600 million, Adj. EBITDA of $893m and adjusted EPS of $3.20. Management further stated that 70% of the revised guidance is related to COVID-19 impacts that will bounce back. In 2022, we assume the 70% impact from COVID-19 has normalized, the base business continues to grow, and the Latin American business stems the losses it is currently experiencing. The Pipeline and Industrial Infrastructure Services segment achieves revenue of around $4.6 billion at a 6% operating income margin and the Electric Power Infrastructure Services segment achieves revenue of $8.3 billion at a 10% operating income margin. This leads to an Adj. EBITDA of approximately $1.1 billion and an adjusted EPS of approximately $4.15. At 12x P/E, we arrive at a price target of approximately $50 or an approximately 50% return.

It is also worth noting that the Company is increasningly focused on free cash flow generation. Despite the reduction in EBITDA guidance, Quanta has maintained its FCF guidance of $400 to $600 million in FCF. Some of that FCF is due to working capital. This represents a 10.6% FCF yield.

Catalyst

2021 guidance 

share buyback