Description

[Please excuse the formatting on VIC]

TRR

Leading U.S. engineering services firm with greater than 50% upside on a relative and absolute basis. Misunderstandings around 1) the value of a recent acquisition, 2) legacy liabilities, and 3) the company’s limited oil/gas exposure provides opportunity to buy growth at a deep value price.

We recommend TRC Companies, Inc. (the “Company”, “TRC”, or “TRR”) as a long.

Investment Thesis

1.      Growing end-markets translates into strong backlog growth

a.       Environmental – increased regulatory requirements and the shift to natural gas from coal power plants is leading to strong demand for TRR services. Note that the historical backlog for the Environmental segment has been flat due to the wind-down of the Exit Strategy business offset by the growth in air quality testing, hazardous waste remediation and pipeline permitting projects.

b.      Energy (aka. Utilities, not oil/gas) – Aging power/utilities infrastructure coupled with a trend towards outsourcing is leading to strong demand for TRR services.

c.       Infrastructure – increased federal/state budget for infrastructure spending along with a trend towards outsourcing is leading to strong demand for TRR services

d.      Based on TRR’s strong position within each segment and the industry tailwinds exhibited, TRR has grown its NSR backlog at a CAGR of 9% (excluding the latest Pipeline segment acquisition) even through the process of winding down its Exit Strategy segment

2.      Integration of Pipeline segment

a.       Mgmt has yet to provide more color around the performance behind the acquired Pipeline segment. Based on our conversations and concrete results from the mgmt team (completed separation from Willbros within 3 months from close of acquisition), we are strong believers in mgmt’s ability to right-size the business.

b.      TRR paid $127.5m in total for $154.4m of LTM revenue, zero operating income, and implied EBITDA of $1.8m. On the surface this looks like an expensive acquisition, but based on our conversations with management, there is a substantial amount of cost take-out opportunities present in the Pipeline segment as it was previously burdened with a substantial amount of corporate overhead while being a part of Willbros Group. Mgmt is confident that it can decrease the G&A expense in the Pipeline segment (21.7% of NSR) to that of TRR (9.1% of NSR) – this would effectively yield an implied EBITDA of $21.3m and a purchase multiple of 6.0x EBITDA including synergies.

3.      Complete wind-down of Exit Strategy segment

Historically, a large portion of TRR’s business was in the “Exit Strategy” segment, which involves the transferring of environmental risks of contaminated properties (think manufacturing plants) from the business owner to TRR for clean-up. This business segment was unattractive in the sense that 1) the full burden of the liabilities were unknown and borne by TRR, 2) the ROIC was low, and 3) the complexities around the accounting for this segment made TRR a difficult business for the investing community to analyze. Since then, TRR has wound down its “Exit Strategy” segment. As of today (12/31/15 balance sheet) the total liabilities remaining is $31m of which $5.2m is covered by TRR’s insurance plan. The remaining $25.8m liability is spread across 1-5 years. By applying a 10% discount rate and a tax rate of 38%, the PV of the remaining liabilities is $12.0m – negligible to the value of the overall business.

4.      Renaming of the Energy segment

Given its small size, limited research coverage, and multiple segments, we believe that this company is misunderstood as an “energy” company.  Management has indicated their commitment to better communicating their segment level exposure. This may simply entail more precisely labelling the Energy segment as “Utilities” which would better reflect the end-market that TRR services. As it is now, TRR does not screen well as potential investors are dissuaded from TRR due to its perceived oil/gas exposure. In reality, TRR’s oil/gas exposure is only 15% of its Environmental segment or ~8% of its total NSR revenue. Out of the 8% oil/gas exposure, 60% is midstream, further providing investors comfort that TRR will be less impacted by the current oil/gas environment. PF for the Pipeline segment, total oil/gas exposure is 32%. Note that the ~60% of TRR’s total oil/gas exposure is midstream and will benefit from the new PHMSA regulations (https://www.transportation.gov/fastlane/5-things-you-should-know-about-hazardous-liquids-nprm). 

Company Overview

TRC Companies is an engineering services firm that focuses on the Environmental, Energy (aka. Utilities, not oil/gas) and Infrastructure markets, primarily in the U.S.

Historically, a large portion of TRR’s business was in the “Exit Strategy” segment, which involves the transferring of environmental risks of contaminated properties (think manufacturing plants) from the business owner to TRR for clean-up. This business segment was unattractive in the sense that 1) the full burden of the liabilities were unknown and borne by TRR, 2) the ROIC was low, and 3) the complexities around the accounting for this segment made TRR a difficult business for the investing community to analyze. Since then, TRR has wound down its “Exit Strategy” segment. As of today (12/31/15 balance sheet) the total liabilities remaining is $31m of which $5.2m is covered by TRR’s insurance plan. The remaining $25.8m liability is spread across 1-5 years. By applying a 10% discount rate and a tax rate of 38%, the PV of the remaining liabilities is $12.0m – negligible to the value of the overall business.

As of today, TRR operates in 3 end-markets: 1) Environmental – 51% of net service revenue (“NSR”), 2) Energy (aka. Utilities, not oil/gas) – 36% of NSR, and 3) Infrastructure – 13% of NSR. NSR is defined as gross service revenue (“GSR”) earned by TRR less the costs associated with paying out subcontractors on parts of the whole project. Note that the nomenclature for TRR’s Energy segment is misleading. Rather than being focused on oil/gas, the Energy division is solely focused on the Utilities industry, which is a growing market. TRR’s pre-acquisition total oil/gas exposure is 15% of the Environmental segment, or ~8% of total NSR revenue. Within each end-market, TRR operates in niche sub-segments where it is one of a few dominant players that we believe been able to hold or gain market share. While we have had little success finding relevant market data, NSR backlog grew by 23.2% over the last 12 months, excluding acquisitions (9% NSR backlog CAGR over the last 4.5 years excluding the Pipeline segment acquisition). This tremendous growth has yet to flow through revenue thus making TRR a timely investment opportunity.

The Company also recently announced and closed (on 11/30/15) a transformative acquisition of Willbros Group’s pipeline services business (“TRC Pipeline Services” or the “Pipeline” segment). TRR paid $127.5m in total for $154.4m of LTM revenue, zero operating income, and implied EBITDA of $1.8m. On the surface this looks like an expensive acquisition, but based on our conversations with management, there is a substantial amount of cost take-out opportunities.  As part of Willbros Group, the Pipeline segment was previously burdened with a substantial amount of corporate overhead. Management is confident that it can decrease the G&A expense in the Pipeline segment (21.7% of segment NSR) to that of TRR’s historical rate (9.1% of NSR). This expected cost savings would effectively yield an implied EBITDA of $21.3m and a purchase multiple of 6.0x EBITDA, excluding any potential revenue synergies.

This acquisition was incredibly opportunistic as Willbros Group was going through financial difficulty and needed to shed non-core assets, which coincidentally fit extraordinarily well with TRR’s business. This acquisitions falls right in-line with TRR’s business strategy as it has been pursuing the pipeline services business for more than three years. There is substantial client overlap with TRR’s existing oil/gas clients, but in all cases there is no overlap in services provided, thus presenting synergy opportunities without any revenue cannibalization. The key management team of the division are all coming with the business to ensure continuity. Management has previously made multiple tuck-in acquisitions throughout the years at reasonable prices and have been very successful in integrating these business within TRR. This “know-how” can be seen with the quick, three month integration of back-office functions of the Pipeline segment.

Environmental segment (51% of NSR revenue)

TRR operates in niche areas within the Environmental segment and commands a dominant position within the following areas: 1) air quality testing, 2) hazardous waste remediation, and 3) pipeline permitting.

-          Air quality testing – TRR is one of the top 5 competitors nationally, the #1 player in the Northeast, and the #3 in the Southeast/Midwest. Air quality testing is a recurring business in that customers are required to retest annually, sometimes with stiffer regulations.

-          Hazardous waste remediation – TRR is one of the top 10 competitors nationally and has very strong presence in certain regional markets. TRR manages the remediation project and subcontracts the actual remediation process to a third party contractor who uses heavy equipment to dig up the soil. It thereby protects itself from environmental liability by limiting the scope of the contract.

o   Note that this business is unrelated to the Exit Strategy segment that TRR is on the tail-end of winding down. TRR does not take on any further environmental related liabilities from its ongoing business.

-          Pipeline permitting – TRR is the go-to company in the East and one of the top players nationally, if not the top. It responds to all RFQs within the natural gas end-market. The pipeline industry is buoyed with tremendous tailwinds due to the conversion of existing coal power plants to natural gas. There has been a trend for utilities moving to an outsourced model instead of hiring the headcount internally as the market recovers.

Energy segment (aka. Utilities, not oil/gas) (36% of NSR revenue)

TRR is the #1 player in engineering services for power/utilities and is only operates within the electrical transmission/distribution sub-segments, not energy generation. There is a trend towards outsourcing within this industry as the average age of utility employees continue to increase. Due to TRR’s expertise, it has been gaining share over the last couple of years as can be seen in the segment’s NSR backlog growth. The U.S. electricity distribution infrastructure is archaic, averaging over 40 years, old and requires increasingly more work to ensure a consistent supply of power to match growing demand.

Infrastructure segment (13% of NSR revenue)

TRR’s primarily receives work from the Department of Transportation and expects to see growth in revenue due annual growth in federal/state infrastructure budget. This end-market is also exhibiting outsourcing trends due to increasing average age of industry employees. The percent of revenue from repeat customers is ~94% indicating strong revenue stickiness. While there is a formal procurement process for each project, TRR based on its reputation and long-term relationships.

Pipeline segment ($154.4m LTM revenue – 6/30/15)

TRR closed on the Willbros Group pipeline services segment on 11/30/15. Since then, TRR’s mgmt team has been right on track in integrating this business into TRR – the Pipeline segment being functionally integrated as of February 2015 (including: accounting systems, ERP systems, IT, payroll, etc.). TRR has already stopped operating under the Transition Services Agreement (“TSA”) with Willbros Group. Although we all know there has been pressure within the oil/gas market, the Pipeline segment’s business is 60% midstream, with the remainder split evenly between upstream and downstream – this should provide TRR with ample stability in current volatile markets. The Pipeline segment will also benefit from regulatory tailwinds, which requires the upgrade of ~200,000 miles of pipes which transport hazardous materials (predominantly crude oil) to meet the new regulations proposed by PHMSA on 10/1/15 (https://www.transportation.gov/fastlane/5-things-you-should-know-about-hazardous-liquids-nprm). Mgmt has referenced up to 700,000 miles of pipes which require assessment to continue to operate.

Near Term Catalysts

-          Continued growth in backlog and conversion of backlog into accelerated revenue growth.

-          Integration of Pipeline segment and realization of cost synergies.

-          Improved investor communication.

-          Note that TRR will be reporting Q3FY16 earnings early May (no date set) and we are hoping to get an incrementally better view on mgmt’s plans with the Pipeline services business.

Risks/ Mitigants

-          M&A Integration – Willbros Group was a distressed-seller which can be good news or bad. Given where we are in the cycle, management’s successful track record on M&A integration and their deep knowledge of the asset, we are optimistic that they bought right and will create value.

-          Oil & Gas exposure – at 32% of the PF business – we think the strength of the other end-markets should still yield growth well in excess of GDP.

Valuation and Price Target

Comps

In the engineering space, the best comps for TRR are outlined below. Assuming the median LTM EBITDA multiple of 10.2x for TRR implies a target price per share of $18.44 – a 116.7% premium over current share price.

FCF yield

A niche engineering business with strong backlog, revenue growth (along with beneficial industry tailwinds), cash flow generation profile, and solid balance (debt to PF LTM Adj. EBITDA of 1.7x) should be valued using no more than an 8% free cash flow yield (vs. a current yield of 13%). An 8% free cash flow yield on PF LTM (2015) Adj. EBITDA implies a price per share of $13.58 – 59.5% premium over current share price of $8.51.

Catalyst

Near Term Catalysts

-          Continued growth in backlog and conversion of backlog into accelerated revenue growth.

-          Integration of Pipeline segment and realization of cost synergies.

-          Improved investor communication.

-          Note that TRR will be reporting Q3FY16 earnings early May (no date set) and we are hoping to get an incrementally better view on mgmt’s plans with the Pipeline services business.