Description

Shawcor Ltd.

Summary

We focus on smaller companies with “Ft. Knox” balance sheets and large & sustainable free cash flow yields and we are typically seeking a double-digit FCF yield or higher on an unleveraged basis. The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation through share buybacks, debt reductions, dividends, or accretive acquisitions. Obviously, it is important we have a management team that cares about shareholder value. We focus on small-cap stocks because there is a much better chance to find an attractive investment opportunity which is underfollowed or undiscovered.

Shawcor Ltd (SCL.TO) is an undervalued Canadian industrial and infrastructure company with a dominant position in offshore pipeline coating which is rebounding sharply from very depressed levels due to Covid shutdown. The Company is a growth-oriented global material sciences company serving the Infrastructure, Energy, and Transportation markets. The Company operates through a global network of fixed and mobile manufacturing and service facilities located around the world. SCL was written up by funkycold87 in Nov 2021 which is a great writeup and we recommend it highly. While SCL’s share price is higher, its results and execution and new contracts are all much improved and we believe significant upside remains.

During 2019 to 2021, SCL pursued a portfolio optimization and targeted segment growth strategy with its three segments of Composite Systems, Automotive and Industrial, and Pipeline and Pipe Services. This strategy included focusing on products and services that offered the greatest opportunities for differentiation, higher margins, and growth. As part of this strategy, SCL has expanded its business outside of energy markets during the 2019 to 2021 period through organic investments to expand capacity in its Automotive and Industrial segment and acquired SCL Composites in April 2019 to address growing demand for fiberglass reinforced plastic underground storage tanks for the retail fuel market. These programs and activities have enabled SCL to grow its non-oil and gas business to about 46% of total revenue in Q2 of 2022.

In 2020 and 2021, SCL completed several actions to optimize its portfolio of products and services and to reduce its overall operating cost base. SCL focused on the highest-value, most differentiated industrial businesses and divested or shutdown non-core activities. Cost optimization efforts included the shutdown or sale of several girth weld inspection branches and 8 fixed pipe coating facilities and the right sizing of its salaried workforce for a total headcount reduction of 28% over the course of the last two years.

SCL share price does not reflect its recent strategic transformation and financial de-leveraging. The company today operates differentiated, high-quality businesses in diverse industrial, infrastructure, and energy end markets. SCL’s Board appointed strong new management team led by CEO Mike Reeves in early 2021 with a clear mandate of value creation. Reeves’ focus on key businesses with technological leadership and his willingness divest noncore assets has begun to show through: the balance sheet is substantially de-levered and profit growth is beginning to accelerate. SCL has reduced net debt by over C$150m over the past two years. Net debt to EBITDA is currently about 2x with a target to reduce this ratio to 1.5x, probably by year end 2022.

At today’s price of about C$8, SCL’s stock is substantially undervalued. The Company’s shares trade at about 7x its 2021A EBITDA of C$106M, a modest level based on comparable companies’ median and strong operating fundamentals. While SCL’s adjusted EBITDA was relatively stable for 6mos 2022 versus prior year, management has repeatedly noted it expects SCL results to be “substantially higher” in H2 of 2022, especially in Q4. Further, the strong performance in Composite Systems and Automotive & Industrial segment is masked by Pipeline and Pipe Services depressed results in H1 of 2022, which are rapidly improving (see Segment Results below).

SCL has momentum in all three of its core business segments – Composite Systems, Automotive & Industrial, and Pipeline and Pipe Services, as discussed below. Mike Reeves is quite impressive and is laser-focused on converting SCL into a simpler, more resilient, stable, cash-generative business with an increasing focus on non-oil and gas businesses that are more predictable and less volatile. SCL has aggressively reduced its fixed cost base over the past two years with SG&A about C$100m per year lower than previously.

SCL’s three core business segments have very strong business niches which we believe have multi-year growth profiles over the next few years. SCL was for many years a family-controlled company with disparate businesses that was focused primarily on the oil and gas industry which produced volatile and unreliable financial results. This history and an over-leveraged balance sheet have severely depressed SCL’s multiple as investors take a “show-me” approach to SCL’s turnaround.

We value SCL on a segment basis to better reflect its segment values. We believe Composite Systems and Automotive and Industrial can together achieve C$140m of adjusted EBITDA less C$20m of corporate expense for C$120m after corporate expense. (They are already at this level on an annualized basis for 2022). We believe these industrial and infrastructure businesses can be valued at 8x adjusted EBITDA or C$960m together as investors appreciate their high-quality characteristics. We believe Pipeline and Pipeline Services segment can achieve adjusted EBITDA of C$50m over the next year or two and can be valued at 4.5x adjusted EBITDA or C$225m. Together, we see a combined value of C$1.2b for all three segments less C$100m in net debt by year end 2023 for a market value of C$1.1b or about C$15 per share.

                                                         Segment Results

Business Description

Shawcor Ltd (SCL.TO) is an undervalued Canadian company whose share price does not reflect its recent strategic transformation and financial de-leveraging. This underfollowed Toronto-based global industrial technology company started in 1966 providing specialty pipeline coatings against failures from corrosion, extreme temperatures, and mechanical damages. Over time, SCL expanded its product offerings beyond energy pipelines into several infrastructure end markets, including communication, automotive, and nuclear energy, and even water storage and conservation solutions.

Composite Systems

• Composite spool-able pipe is cost-effective to install, flexible, and durable in harsh environments and serve oil and gas gathering and recovery, water transportation, and CO2 injection in the latest up-and-coming carbon capture utilization and storage (CCUS) green solutions.

• Underground fiberglass oil & gas storage tanks for retail fuel stations that are more environmentally friendly and anti-corrosive compared to traditional steel tanks.

• Water, wastewater, and stormwater storage tanks, filtration, and treatment systems that conserve water and prevent costly pollution disasters from occurring.

•  Automotive & Industrial

• High cost-of-failure heat shrink, cold shrink cable protection sleeves and cable products used in automotive, electrical utility, communication, and nuclear industries.

• Pipeline and Pipe Services

• Anti-corrosion, pipeline coating solutions, and pipeline-related consulting services supporting the largest oil and gas operators.

Strong Management and Ownership Oriented Towards Disciplined, Long-Term Value Creation

SCL has transformed into a growth-oriented industrial and infrastructure company over the past 2 to 3 years. SCL has dramatically reduced its fixed cost base by over C$100m per year, exited non-core and more volatile businesses, sharply reduced net debt by close to C$150m, and simplified its focus to three high quality, resilient, and cash-generative business segments with excellent long-term growth prospects. Mike Reeves joined as CEO in March 2021 and has moved quickly to simplify and focus SCL on its strongest and most reliable businesses with strongest growth prospects. We believe the market still sees SCL as a volatile oil and gas business and is not paying attention to the large value-creating changes that SCL has made under Reeves and his team.

Attractive Absolute Valuation

SCL trades at an attractive absolute valuation of about 7x adjusted EBITDA in 2021 and 6x our estimated adjusted EBITDA for 2022 of about C$120m and less than 5x our adjusted EBITDA for 2023. While investors continue to view SCL as a volatile, highly leveraged oil and gas related business due to its history, the Company has transformed into a simplified, more stable industrial and infrastructure company with reliable operating results and long growth runway in its three core business segments. SCL has divested weaker and more volatile businesses and retained those with high market shares and strong market positions. In the most recent Q2 of 2022, non-oil and gas businesses were about 46% of total revenues. Further, SCL has aggressively reduced its net debt position over the past two years by almost C$150m to date and is currently comfortably leveraged at about 2x adjusted EBITDA with a target of 1.5x by year end 2022.

Large Discount to Comparable Companies

SCL is trading at a huge discount to the industrial and infrastructure comparable companies, many of which trade at 8x to 10x adjusted EBITDA. We believe as SCL continues to execute and deliver stable operating performance, investors will come to appreciate the large improvement in the business model and rerate SCL to a more appropriate multiple. We believe the Composite Systems and Automotive & Industrial segments are stable, high-quality businesses with long-term growth paths which warrant a multiple of 8x to 10x adjusted EBITDA or more. We assign a multiple of 4.5x to Pipeline and Pipe Services segments. Based on these multiples, we reach a valuation of $15 per share or more for SCL.

The chart below is dated and from SCL’s investor presentation in March 2021 but provides a perspective on how large the discount in SCL’s market value is relative to companies comparable to its core business segments.

Strong Performance by Composite Systems and Automotive and Industrial

Both Composite Systems and Automotive and Industrial segments are demonstrating strong growth as management’s plan to shift SCL’s business model to a simpler, more resilient, and more stable business model focused on Industrial and Infrastructure markets takes hold.

Composite Systems had 2021 revenue of C$375m, with 6mos of 2022 revenue growing 44% versus prior year. Composite Systems had 2021 adjusted EBITDA of C$54.5m with a 14.5% EBITDA margin and 6mos of 2022 adjusted EBITDA of C$37.6m, growing 58%, and a 15.6% EBITDA margin

Automotive and Industrial had 2021 revenue of C$263.5m with 6mos of 2022 revenue growing 20.4% versus prior year. Automotive and Industrial had 2021 adjusted EBITDA of C$45.2m with a 17.2% EBITDA margin and 6mos of 2022 EBITDA of C$32.2m, growing 39%, with a 20% adjusted EBITDA margin

Strong Market Position and Growth Potential in Composite Systems

Composite Systems segment has market leading positions in both Spool-able Pipe segment and its Underground Composite Tank segment. These two products each represent roughly 50% of sales and adjusted EBITDA for the Composite Systems segment. Spool-able Pipe is critical to connect new oil and gas wells to trunk lines and SCL’s spool-able pipe product is the North American leader in 4-inch diameter and under spool-able pipes. Spool-able pipe of 5-inch and 6-inch diameter are a large market that is dominated by a competitor and its customers have few alternatives. SCL has recently introduced both 5-inch and 6-inch spool-able pipes and believes it will take significant market share in the North American market. We believe the outlook for SCL’s spool-able pipe business is very strong over a multi-year period.

SCL is the leader in North America in its Underground Composite Tank business in gas stations, convenience stores and sees strong demand in this market from new convenience stores and replacing existing Underground Tanks. SCL is by far the largest provider of underground storage tanks to the North American market with a market share estimated at about 65%. Tanks need to last for 30 years so track record and credibility are important and this is a big part of SCL’s moat. SCL believes gas stations and convenience store operators are doing well and have robust plans to make capital investment in this business. SCL sees high demand for the “rest of this decade and well into the next”.

Strong Market Position and Growth Potential in Automotive and Industrial

Automotive and Industrial includes two key businesses - Shaw Flex which is a highly engineered wire and cable manufacturing business and DSG-Canusa which is a manufacturer of high quality and high consistency heat shrink tubing and makes automated application equipment used to install that heat shrink tubing. Industrial and infrastructure is about 70% of segment sales and automotive oriented business is about 30% of segment sales. Shaw Flex is highly engineered, low voltage wire and cable to the industrial and infrastructure markets. It meets very high-performance standards required in nuclear, 5G, NASA, hydro power and wind power. It is a collection of a lot of relatively small and high margin niche markets that don’t attract much attention from the large wire and cable manufacturers. The moat is the highly engineered and custom designed products for end users to meet their needs and make sure products are safe in critical applications. Shaw Flex has been primarily focused on the Canadian market to date and is just starting to enter the U.S. market where management believes there are large growth opportunities.

DSG-Canusa is the heat shrink business and is focused on polymer science and creation of heat shrink tubes. This business is about 50% automotive and 50% industrial and infrastructure. These products provide physical protection against short circuits and prevent water or other fluids getting into places you don’t want them. DSG-Canusa is the number two player globally with TE Connectivity, formerly Tyco, as number one. This business did not historically receive a lot of attention and capital but this has shifted in the last few years and DSG-Canusa has taken share from TE Connectivity in recent years. These products are highly engineered and support critical applications in uses for end customers.

Pipelines and Pipe Services Should Rebound Strongly

Pipeline and Pipe Services segment had 2021 revenue of C$507.5M, with 6mos of 2022 revenue declining 38.4% versus prior year. Pipeline & Pipe Services had 2021 adjusted EBITDA of C$20.9M and a 4.1% EBITDA margin with 6mos of 2022 EBITDA of C$-(8.2M) and a negative 4.7% EBITDA margin.

The Covid pandemic completely shut down the offshore pipeline business in early 2020 and, in response, SCL dramatically cut its fixed cost base and exited 9 plants and sharply reduced its workforce. SCL is well positioned to benefit from a large backlog of contracts as offshore oil and gas projects restart. SCL is the leading pipeline coating company in the world with limited viable competitors. The pause in 2020 worked its way through the system and Q1 results hit trough levels as it reported an EBITDA of CAD ($7.5m) (EBITDA margin of -9%). Profitability recovered to nearly EBITDA breakeven levels in 2022 Q2.

By 2022 year-end, it is estimated EBITDA margin will be back to 10% and higher going forward. Evidence of rebound was shown in August 2022, as SCL announced 2 major contract wins for the Pipe Services segment, one in Guyana worth C$40-$50M, another worth C$500M, the majority of which will materialize in 2023’s results. The latest contract win itself will double the segment’s 2022 revenue and may add C$50M+ to EBITDA. The management has talked multiple times about an ‘multi-year upcycle’ that will benefit this division, implying more upside to the segment and the company as more contracts are awarded going forward.

Need for Oil and Gas Infrastructure Maintenance Spend and Investments:

According to Business Roundtable, the U.S. energy industry is supported by 76,000 miles of crude oil pipelines, more than 1/3 of which were installed before 1960. The need for inspection, maintenance, consultancy, upgrade and replacement of pipelines and storage tanks, as well as the sustained high energy prices and outlook this year (strengthened by the increasing desire for energy independence), both set a strong runway for SCL’s products and services offerings globally in the foreseeable future.

Composite Systems Technology is a Better Value Proposition than Traditional Steel and Metal Products

Metal-based oil storage tanks and pipelines have historically been cheaper and widely used until hazardous waste from tank erosions & sustainability issues rose to prevalence in recent years. Although more expensive than steel pipes and tanks, composite materials have much longer expected lives and are much less subject to corrosion. The volatile steel and metal prices observed in the past year have tightened the price spread between steel and composite products. Furthermore, coupled with increased environmental mandates, scrutiny, and rising financial liabilities in cases of pollution, composite pipes and tanks are an increasingly compelling solution.

Increasing Electrification and Demand of Auto, 5G, Nuclear, and Communication End Markets

SCL’s strong reputation for reliable high-tech cable protection products (heat shrink & cold shrink sleeves) along with the high cost of failure (e.g. vehicle fires, nuclear plant failures) allows the company’s Automotive & Industrial segment to increase its market share while maintaining strong margins in the highly regulated end-market in the auto & industrial industries. Increasing automotive electronic content and electric vehicles demand and production growth should drive strong future growth for the A&I segment.

Market-Leading Customer Base

SCL recently shared its major global customers across the various segments which represent an impressive list. Many of these customers are market leaders in their respective markets. They include, in Composite Systems, 7-Eleven, Kwik Trip, Wawa, RaceTrac, Murphy Oil, and Maverick. In Automobile and Industrial, customers include Tesla, BMW, Boeing, Airbus, Mercedes-Benz, Volkswagen, GM, Sumitomo Electric, ABB, Aptiv, Leoni, Bell (telecom), Hydro One, Hydro Quebec, Ontario Power Generation, Rogers, and Wesco. In Pipeline & Pipe Services customers include Chevron, Subsea 7, Saipem, Sumitomo Corporation, McDermott, Tenaris, Technip, and FMC.

Conclusion

We value SCL on a segment basis to better reflect its different businesses. SCL is currently valued at ~7x 2021A EBITDA of C$106.3m. We estimate 2022 EBITDA to be ~C$120m and 2023 EBITDA to be ~C$170m after the recent C$500m contract win.

We believe the Composite Systems and Automotive and Industrial segments can together achieve C$140m of adjusted EBITDA less C$20m of corporate expense for C$120m after corporate expense. (They are already at this level on an annualized basis for 2022). We believe these industrial and infrastructure businesses can be valued at 8x adjusted EBITDA or C$960m together as investors appreciate their stability and resiliency and high margins and growth opportunities. We believe Pipeline and Pipeline Services can achieve adjusted EBITDA of C$50m or more over the next year and we value this at 4.5x adjusted EBITDA or C$225m. Together, we see a combined value of about C$1.2b, less C$100m in net debt by year-end 2023, for a market value of C$1.1b or about C$15+ per share.

 All numbers in C$ unless otherwise noted

              Geographical Information

              Quarterly Consolidated Results

Exhibit A - Comparable Multiples

For Composite Systems, we assume an 8x EBITDA multiple to the segment’s 2023E EBITDA, a conservative measure as the division is experiencing very strong revenue growth (at ~40%) and strong margins (at ~16%).  We do not see growth slowing anytime soon given the strong energy prices and levels of activity.   For comparable companies, NOV Inc (~9.5x 2023E EBITDA) and Baker Hughes (~8x 2023E EBITDA) were listed by SCL as competitors, although SCL’s Composite System segment substantially outperforms both competitors in terms of revenue growth and EBITDA margins.

For Automotive and Industrial segment, we assume a similarly conservative 8x EBITDA multiple to the segment’s 2023E EBITDA as revenue growth is strong (at ~20%) and strong margins (at ~20%), supported by increased multi-year production outlook in 5G telecommunications, EVs, nuclear powerplant refurbishment (as an alternative energy source to fossil fuels).

Comparable companies to A&I segment include TE Connectivity (~12x 2023E EBITDA), CYG (~7.5x 2023E EBITDA), Nexans (~8x 2023E EBITDA), and Prysmian Baker (~9x 2023E EBITDA) were all listed by SCL as competitors, although SCL’s A&I segment outperforms the median of the comp set in terms of revenue growth and EBITDA margins.

For Pipeline & Pipe Services, we assume a 4.5x EBITDA multiple to the segment’s 2023E EBITDA because of the segment’s recent years of revenue declines and profitability challenges as part of oil and gas’s down cycle and Covid-19 impacts. This valuation equals a very conservative 0.35x of the segment’s 2023E Revenue (as SCL has just divested its loss-making polyethylene pipe business for 0.25x Revenue in 2Q 2022).  We believe this valuation is conservative given the extraordinarily strong activity levels evident with the recent contract awards.  There is also considerable upside optionality as and when oil and gas activity levels normalize, based on historical earning power of this segment.

For comparable companies, Tenaris (~5x 2023E EBITDA and ~1.3x 2023E Revenue) as identified by SCL management and Helix Energy Solutions Group (~4.5x 2023 EBITDA and ~0.7x 2023E Revenue) are good reference points. I included the revenue multiples because as of 2Q 2022, SCL’s Pipeline and Pipe Services were still incurring negative EBITDA.

Catalysts

·       Increase in revenues and adjusted EBITDA in 2022 and 2023 due to strong growth trends and solid market positions in Composite Systems segment and Automotive & Industrial (A&I) segment and Pipeline and Pipe Services segment.

·       Low valuation of SCL at 7x 2021 adjusted EBITDA and 6x 2022 adjusted EBITDA and less than 5x 2023 adjusted EBITDA as investors recognize the transition to an industrial and infrastructure business model.

·       Consistency of operating results and simplification of business model highlights SCL’s transition to more resilient and consistent and higher-margin industrial and infrastructure businesses

·       Operating results in 2023 and 2024 highlight the cash-generative and non-capital-intensive nature of SCL’s three core business segments – Composite Systems, Automotive and Industrial, and Pipeline and Pipe Services segments.

·       Stable commodity prices in oil and gas boost long-term maintenance and growth CAPEX by operators.

·       Continued major contract awards for the Pipeline and Pipe Services segment accelerate and magnify the segment’s turnaround into profitability

·       Supply chain easing, especially with semiconductors, to allow materializing of global EV vehicle production

·       Increased infrastructure investment spending in ESG and climate-related initiatives, such as CCUS projects and switch from steel-to-composites oil storage tanks

·       Continued tightening price spread of composite-to-metal oil & gas storage tanks.

·       Increased nuclear refurbishment activity in assuring energy security amid increased global geopolitical tensions.

Risks

·       Petroleum resins supply shortage/unavailability experienced last year resurface, limiting the growth and hamper margins of Composite Systems segment.

·       Energy commodity prices to decline significantly, resulting in delayed maintenance CAPEX spend by major oil and gas operators and impacting Pipeline and Pipe Services’ performance and turnaround.

·       Increasing scarcity of rare-earth elements associated with production of EVs (lithium, cobalt, etc.) resulting in lowered EV production outlook, resulting in lowered demand for SCL’s heat-shrink cable sleeve products.

Catalyst

See above.